from Follow the Money

Dani Rodrik, Steve Waldman, China’s impact on US export prices and the risk of “financial” Dutch disease …

April 30, 2007

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Dani Rodrik didn’t take long to stir up the blogosphere (see Steve Waldman, among others).  

Rodrik makes an interesting point:   Trade doesn’t cut inflation.   Sure, it lowers prices for imports.  But it also raises prices for exports …

Let’s step back and think for a second how that applies to the United States’ trade with China.     The US imports a lot of stuff from China (almost $300b worth last year).  All the talk of the China price (or a trip to Walmart) suggests that Chinese supply has kept prices for a lot of goods that China makes pretty low.   

The US doesn’t export that much stuff to China.   To be sure, Boeing sells quite a few planes to Chine airlines – very strong foreign demand for Boeings has offset weak US demand for Boeings recently, and presumably pushed the price of Boeings up a bit.    But in aggregate, US goods exports to China are 20% of US goods imports from China.   China tends not to pay full price on many of the “services”  -- think audiovisual services like films and television programs – that it imports from the US, so adding services wouldn’t change the balance enormously.

So maybe the overall impact of trade with China has been to lower prices?   Not so fast – 

While the US doesn’t sell that many goods to China, others do.  Capital goods producers (think Germany).  And above all commodity producers.   The “China price” for copper, iron ore and soybeans is high – not low.   One effect of China’s growing trade with the world has been to push up the price of commodities – and thus to push up the price of a certain set of  US imports …

It also has pushed up the price of food since corn and sugarcane are – at least with a bit of help – substitutes for gasoline at the “China” price for gasoline.   

There is another effect as well.   China doesn’t buy a lot of US goods.   But it does buy a lot of US assets.  

Between June 2005 and June 2006, China bought about $50b of US goods  and a bit less $195b of US long-term debt.   That needs to be qualified a but, since China also bought about $10b of foreign bonds from US residents and sold a bit over $20b of short-term debt, so net Chinese demand for US assets and assets owned by US residents was around $180-185b range.  Still,  China buys way more US financial assets than US goods.

The best data comes from the survey, which isn't available for a normal calendar year.  But we do know that for all of 2006, the US imported $288b worth of goods and sold $55b worth of goods to China – and it is likely that over that period China bought around over $200b worth of debt.  

Chinese reserve growth picked up even more this year, so it looks like the US might be on track to export $300b of debt, if not a bit more, to China in 2007.

That demand presumably increases the price of long-term debt.    Or, expressed differently, cut US long-term rates (See Francis Warnock: here, and here).

It also has pushed up the price of things that generate predictable returns that can be securitized.   Think roads and bridges.   Think mortgages – and then think houses.   

At least houses in those parts of the country that don’t produce goods that compete with Chinese goods.    Think New York.   Think DC.  Or the Bay Area.   New York and DC produces most of what the US actually exports to China right now (treasury bonds and securitized mortgages, generally with an Agency guarantee).    Trade with China has pushed down the price of PCs – and TVs.   Maybe it will push down the prices of cars in the future  But it also probably has pushed up the price of gasoline – and the price of living space.   

I certainly am paying more for the same space than I did a few years ago … 

That brings me to a question that Steve Waldman posed in a post last week:  has the surge in financial demand for US assets – a surge that has come overwhelming from the official sector – produced a kind of Dutch Disease in the US.  The financial sector has boomed, but the rest of the economy has atrophied?  

It is an interesting question because both China and the commodity exporters – the most obvious beneficiaries of China’s demand for goods – buy a lot more US financial assets than they buy US goods.   The impact of export prices that Rodrik identifies presumably shows up most strongly in the price of those financial assets.  That after all is what the US really exports to China. 

Some of those assets are pretty cheap to produce – selling US treasuries to the PBoC, BoJ and SAMA is easy and doesn’t take many people.  

But that isn’t the only US financial asset that the US sells to the rest of the world.   The US sells a lot of mortgages to the world’s central banks.   They aren’t called mortgages of course.   They are called Agencies.   Some agency bonds are issued to finance Fanny’s own mortgage portfolio, some just have a guarantee from Fanny or Freddie.    But a lot of them – about $100b from June 05 to June 06 – end up in China’s hands, and Russia buys a large amount of Agencies too.    China also buys some high-end (I hope) private “MBS” – that is mortgage backed bonds without an Agency guarantee.

This is where I suspect the Dutch disease argument gets interesting.   Chinese demand at the top end of the MBS market likely spurred a lot of innovation elsewhere in the market.   Much of China’s impact on the market is indirect.  If there is a lot of demand for highly rated MBS tranches, the market needs to find someone to absorb the more risky bits.  

And in a strange way, Chinese demand for assets with little credit risk probably helped create demand for assets with more credit risk as well.

Think what happens when China buys an Agency or a Treasury bond from the portfolio of an insurance or pension company.   The pension fund is left with cash – cash that it needs to put to work to meet its own future obligations (and to make a buck).     And since Chinese demand pushes yields on Treasuries and Agencies down, putting the money back into the Treasury or Agency market isn’t all that attractive.  

The insurance company and the pension fund need to start to search for yield.     Throw in the fact that the US firms haven’t been investing all that much – at least not in the US – and thus haven’t had big borrowing needs, and you really needed to get exotic to find yield.  Or take on a bit of leverage (often through the derivatives market).  That seems to be what happened.  As demand from China  – along with some other Asian economies – and from commodity exporters for “safe’ assets tricked through the financial system, it drove yields down and triggered a flood of innovation to supply US investors with financial products that generated the yields they expected –

Think of synthetic CDOs.  

Think of the leveraged loan market and CLOs.

Think of CPDOS.

Think of pension funds playing in the swaps market because it offers more leverage.

Or read Randall Smith and Susan Pulliam in today’s Wall Street Journal.

There has been a strong bid for “financial engineering” over the past few years.  

And not nearly as strong a bid for “real engineering.”

Making financial assets to sell to China -- and making financial assets to sell to those Americans and Europeans who are selling their existing financial assets to China -- has paid more than making goods to sell to China .... 

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