from Follow the Money

Borders still matter; “the world isn’t as flat as it used to be”

April 29, 2008

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On Monday, Bob Davis of the Wall Street Journal argued that the world isn’t flat, or at least it “isn’t as flat as it used to be.” National borders matter more. Barriers to the free flow of goods – oil as well as grain – are rising. Barriers to the free flow of capital too.

He is right. I actually think he didn’t push his thesis as far as it could be pushed.

Consider energy. Most oil exporters sell their oil abroad for a higher price than they sell their oil domestically. That means that the same good has one price domestically and another price internationally. It isn’t hard to see why they have adopted this strategy: if opening up to trade raises export prices, it can leave those who consume the country’s main export worse off. Only exporting what cannot be sold domestically is one way of mitigating that effect. And for most of the oil exporters, it is one (small) way of sharing the bounty that comes from the country’s resource wealth.

This isn’t new. Saudi Arabia and Russia have long sold oil domestically at a lower price than internationally. What is new is that a host of food exporters are adopting a similar policy.

Argentina was perhaps the first. After its devaluation it taxed its agricultural exports – that was a way of raising revenue, but also a way of keeping food cheap domestically. As global prices have increased, Argentina has stepped up its restrictions on say beef exports – helping to keep Argentina’s national food affordable domestically.

Argentina’s farmers aren’t happy. They prefer selling for a higher price abroad than selling for a lower price domestically.

But with food prices rising, more and more countries seem to be adopting the same policies for their rice and wheat that Saudi Arabia and Russia have adopted for their oil. They only export what cannot be sold domestically at a price well below the world market price. That helps domestic consumers at the expense of domestic producers.

It also is a way – per Rodrik ("if you are Thailand or Argentina, where other goods are scarce relative to food, freer trade means higher relative prices of food, not lower") -- of assuring that the consumers in a food exporting country aren’t made worse off by trade.

Actually, in the current case, it is more a way of assuring that consumers in exporting countries aren’t made worse off from a shock to the global terms of trade that dramatically increased the global price of a commodity. But the principle is the same.

Such policies have produced a more fragmented world. Beef is cheaper in Argentina than in the rest of world. Rice is cheaper in rice-exporting economies than many rice-importing economies. Oil is cheaper in oil-exporting economies. And so on.

Then throw in the subsidies that many oil and food consumers have adopted to mitigate the impact of higher oil prices. China sells oil domestically at a price below the world market price. The Saudis are subsidizing food imports. That implies that the same good sells for a different price in “importing” countries – not just for a different price in importing and exporting countries.

For all the calls to adopt a coordinated response that guarantees that exporters won’t take steps -- like taxing exports -- that hurt the importers as well discouraging increased production in the exporting economy, my guess is that the food crisis will produce more government intervention in the market, not less.

Put it this way: after seeing various food exporting countries take policy steps that would reduce their countries’ profits from exporting to keep domestic prices low, is China’s government more or less likely to trust the market to deliver the resources the Chinese economy needs for its ongoing growth? Or will China conclude that it needs to invest and exercise some control in the production of the resources if it wants to guarantee the stability of its supplies?

Then there are capital flows. Davis highlights the growing presence of sovereign wealth funds in global markets and -- – citing a forthcoming Council on Foreign Relations report by David Marchick and Matthew Slaughter -- the possibility that the US and Europe will respond to the rise of state investors by stepping back from their existing, fairly liberal, policies for inward investment. He also notes that many countries with sovereign funds looking abroad limit investment in their own economies. China is a case in point.

Here I don’t think Davis goes far enough.

Sovereign wealth funds are a lot smaller than central banks. Their assets aren’t growing anywhere near as fast. The overall increase in the presence of the world’s governments in financial markets is much broader and deeper than an analysis that focuses on just sovereign funds would suggest.


There are two big reasons for the rise in the state in cross border capital flows.

The first is that the state in most oil exporting economies controls the revenue from the commodity windfall. In aggregate, the oil exporters are sending more of the revenue globally from $120 a barrel oil back into global financial markets than they are spending or investing at home. Most oil exporters could cover their import bill with $50 or $60 a barrel oil. Some of this surplus goes into sovereign funds – but a lot is going into the hands of central banks. Think of the Bank of Russia, which manages Russia’s sovereign fund, or the Saudi Monetary Agency.

The second is that many states are resisting market pressure for their exchange rates to adjust. China is the obvious example. That requires intervening in the market. Jim Fallows put it well.

But saying that China has a high savings rate describes the situation without explaining it. Why should the Communist Party of China countenance a policy that takes so much wealth from the world’s poor, in their own country, and gives it to the United States? To add to the mystery, why should China be content to put so many of its holdings into dollars, knowing that the dollar is virtually guaranteed to keep losing value against the RMB? And how long can its people tolerate being denied so much of their earnings, when they and their country need so much? The Chinese government did not explicitly set out to tighten the belt on its population while offering cheap money to American homeowners. But the fact that it does results directly from explicit choices it has made—two in particular. Both arise from crucial controls the government maintains over an economy that in many other ways has become wide open. The situation may be easiest to explain by following a U.S. dollar on its journey from a customer’s hand in America to a factory in China and back again to the T-note auction in the United States.

Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.

With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.

The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.


At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.

One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. ...This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. ... Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could).

These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. ....

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth.

The controls on Chinese capital outflows – including the surrender requirement Fallows describes – have been liberalized. China’s banks are now being encouraged to hold dollar these days. But no one in China wants to hold depreciating dollars rather than appreciating RMB, so folks with dollars are still selling their dollars to the government if they can. Conversely, China is continuously tightening its controls on capital inflows. It is also tightening its controls on the banking sector – by raising reserve requirements and forcing the banks to lend funds to the state.

Holding its exchange rate down has a host of subsidiary effects. It creates pressures for price controls (see the Gulf) to limit inflation. And in China, it means that the government has a de facto monopoly on outward capital flows.

China now has the world’s largest current account surplus. That makes it - -and specifically its government – the world’s largest external investor. Ongoing inflows (despite the controls) only add to the funds that China’s government has to invest abroad.

And the process for deciding what to buy remains driven by the state. Consider Richard McGregor’s description of the Chinalco investment in Rio Tinto.

The Aluminum Corporation of China, or Chinalco, spent $14.1bn in conjunction with Canada’s Alcoa, a junior partner in the transaction, to buy into Rio’s UK-listed arm. Executed in a lightning share raid, Chinalco’s purchase is the largest ever single Chinese investment offshore.


As a huge and growing consumer of commodities, China’s concern about the BHP takeover is unsurprising. Nor is Chinalco’s denial that the Rio raid had anything to do with the BHP bid. Such po-faced obfuscation is standard in corporate jousting around the world.

Disentangling Chinalco from China, and China Inc, however, is a much harder proposition. BHP and Rio are dealing with a huge number of demanding shareholders. Chinalco’s investor relations are a lot more straightforward. Its overseas listed subsidiary aside, Xiao Yaqing, Chinalco’s chairman, answers to a single shareholder - the Chinese state. Mr Xiao himself serves at the pleasure of the ruling Communist party’s human resources arm, known as the "Organisation Department", which oversees all top executive appointments in state enterprises. ...

Chinalco’s purchase was funded by the China Development Bank, a state policy bank, a shareholder of which is the country’s sovereign wealth fund, the China Investment Corporation. The sovereign fund, further, owns the largest Chinese investment bank, which is advising Chinalco.

The ambitious CDB itself is no stranger to doing the state’s business offshore. It has been given crucial government mandates, most importantly to fund the expansion of local companies in Africa, primarily for resource projects.

In short, you do not have to be a rabid conspiracy theorist to conclude that Chinalco is a front for China Inc. "Why does BHP really want to tempt the dragon? Chinalco has already made the message clear: they really do not want to see a merger," Geoffrey Cheng, of Daiwa Institute of Research in Hong Kong, told Reuters. "You’re not going against a corporation. You’re going against a nation."


The second point is the more salient one - the perception that Chinalco represents "the nation" in this transaction. A world waking up to a new fact of life in the global economy, the phenomenon of Chinese offshore investment, is naturally going to see a tangled monolith.

McGregor notes that different state bodies often have diverging interests -- so the assumption that China, inc functions as a monolith is wrong (see his article with Geoff Dyer) But his description of the various ways China’s state was involved in the Chinalco bid underscores is hard to reconcile with a world where the state has retreated from the market …

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