Everyone Is Working Hard to Increase Global Trade Imbalances

I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis.

I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.

Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:

South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.

A few days ago the Financial Times had another interesting, related piece.

Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.

…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.

Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation.

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:

A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.

“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”

I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here. Rather than comment I will quote extensively from the article:

Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.

…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.

Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks.

…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange.

Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there.

Comments

[Shaun Rein:]

Another excellent piece Michael. While I do not always agree with your conclusions, your opinions are well-received here. Keep the torrid publishing pace up.

I chime in here because you highlight a good point that many analysts have noticed -- I am dubious of whether interest rate cuts will have any affect on boosting consumer consumption or at least not anytime soon. The interest rate cuts have been spurring more lending to SOEs which slowly if at all trickles down to the middle class Chinese who are the segment that we should be looking at to drive consumption.

I am working on a piece about this in part.

To boost consumption in China, one thing China should do is reduce import duties which causes everyone to shop abroad. Did you know that Chinese consumers buy about $6.5 bil USD worth of luxury products every year but that only 1/3 of that is actually bought in China because tariffs cause products to be 20-30% higher in China and because there is more cachet for shopping in Hong Kong or Europe?

2008 Dec 30 06:36 PM

[David Oliver_:]

I am always by how expensive many products are here in China. Not just imported products but many everyday products including foodstuffs (unless you go to the fruit & vege markets) also seem to cost more than they do back home. Import duties are one factor, another is VAT tax which can be up to 17%.

Lowering VAT would help stimulate consumption, however import duties for consumer products will probably not be lowered in any meaningful way. Even with a huge trade surplus I doubt if the government could bear to see people buying more "foreign" goods.

2008 Dec 30 07:02 PM

[terryliang:]

The simple way to boost the consumption in China is make the medical treatment for free instead of building the highway road and railway. The policy that buy house and return income tax also could work.

2008 Dec 30 09:33 PM

[Feng:]

I agree that a lot of stuff are more expensive in China than in the West. It's quite funny that a pair of Nike shoes made in China is cheaper in the US than in China. However, getting rid of tarrif would benefit the western countries more than China. China has stated very clearly that the biggest contribution that can make to the world economy recovery is to take care of the its own business. So China is not dragging down the world as the US is doing (and letting the world pay the american's bill), but don't expect China to foot the bill for the world.

I think a good way of encouraging spend is government guranteeing minimal level of income to old people, especially those in rural areas.

Making medical care free wouldn't work. Nothing good will come free. That's socialism. And Chinese people and leader don't need other to teach them again that socialism doesn't work.

2008 Dec 31 12:22 AM

[huangthomas:]

I examined carefully everything Chinese government is doing, but I doubt anything will work if they imitate what we are doing. Entirely different culture and economy. We have no idea what the 100 million poor Chinese will do if you double their income from $1/day to $2/day. And their middle class (making $7,200/year) will do. Our poverty line is $8000/year and our middle class make more than $100,000/year. Do not extrapolate American consumer behavior to Chinese consumers'. There is simply no comparison. Well, they may have their own way out, and I wish they do. But it is not ours to see, que sera sera!

2008 Dec 31 06:48 PM

[HaavBline:]

The world will be facing years of economic "rainy days". Those countries that have been saving for raining days will have the means to deal with this problem, will have their own ideas about what need to be done, and will have their own interest as top priority.

Those countries that have failed to save for "rainy days" will have to work with the "saver" countries, accomodate their priorities, and adapt to other countries ideas to support their own "rainy day" needs.

Lets face it, there is no way China can stimulate consumer demand quickly to drive world growth, or even its own growth. It will be up mostly to infrastructure spending stimulus. One just need to look at Japan's repreatly failed attempts to encourage domestic consumer demand growth in the past 20 years. It hadn;t worked, even though Japanese consumers have far more reasons to consume than Chinese consumers. They are far richer, employment is far more stable, healthcare and social safety nets far more developed. And yet for 20 years they refused to follow down the Anglosphere economic religion of debt-financed consumption.

And that brings the need for China to defend its export sector against other countries which has greatly devalued their currencies. Remember that at the first part of 08', China was pursuing new policies that pushed low-value-added light industries AWAY in a attempt to move up the indsutrial ladder. Then the American contagion spreaded globally, and caused severe damage to export sector. None of the policies that encourage climbing up the industrial ladder has changed, if only expediated. So the new policies to support the export sector should be seen as tactical, political, and defensive in nature. To cut down on the number of factory closings and employed workers, until new business and new jobs have been developed.

Jan 01 03:30 AM

[James Lewis:]

Happy New Year Michael,

I am hearing a lot of talk of the Chinese Government considering floating the Yuan in a bid to devalue it again, presuming that it will be devalued by the 'market' due to the weakness of key sectors of its economy. The basis for this thinking being they can cirumvent protectionist backlash from the rest of the world by letting the market devalue the currency.

Just wondering what you think about this. I personally believe due to the way the currency is calculated on the basket using the usd as the main denominator. That the yuan is overvalued against some currencies (GBP/AUD) and at value against some currencies (USD). So I am very interested if is is something they would consider and what the timeframe is for something like this to occur.

The floating of the Yuan..a once in a lifetime theme that is.

James

Jan 02 10:46 PM