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Grassley-Baucus-Adams? And (another) long rant about the Economist …

April 3, 2006

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The Treasury doesn't want to declare China to be guilty of manipulation.   Picking a fight with one of your biggest creditors isn't smart.  Right now, no one is buying more US debt (China buys a lot more than just Treasuries) than the People's Bank of China.   And there is a real risk that declaring China to be "manipulator" might backfire.  Hu might find it politically impossible to change under such a direct threat.

Yet Treasury also almost has to find China guilty of manipulation.    If not in April then in October. Congress wrote the law.  And Congress thinks China is manipulating its currency.    See Roach.

China has not actively driven its currency down against the dollar  -- though it did drive its currency down v. the euro from 2002 v. 2004.  But it is intervening on a massive scale to prevent its currency from appreciating.    And, like Morris Goldstein, I think the evidence that China's intervention impedes effective adjustment of the global balance of payments -- one definition of manipulation -- is pretty good.

  • China has a large and growing current account surplus.   Its current account surplus has increased even as oil prices have surged.   That means its non-oil current account surplus is really big.
  • China's current account surplus has grown as investment has surged - something that normally leads the current account balance to deteriorate.  Its surplus has grown even in the face of ongoing FDI flows that could have safely financed a deficit.
  • If its current account stabilizes in 2006, it will likely do so at a very high level -- particularly for a country growing very, very rapidly.  If China's investment boom stops, conversely, its surplus could get very big very fast.
  • China's real exchange rate has depreciated against the world over the past five years. Yes, China's real exchange rate rose last year on dollar strength, but long-term relying on dollar strength hardly seems like a reasonable way to generate the real appreciation China needs.     There is a reason why China's exports have tripled since 2001 -- a fact that the Economist somehow decided not to mention. 
  • China's real bilateral exchange rate with the US has depreciated as well - inflation has generally been higher in the US than in China. 
  • Productivity differences suggest China should be appreciating v. the US and the world.  So too do does the large gap between China's nominal exchange rate and its PPP exchange rate.
  • China's peg constraints exchange rate moves throughout Asia.
  • The market thinks the RMB is undervalued. Only massive central bank intervention keeps it at its current level.

But China cannot manipulate its exchange rate without also manipulating -- or distorting -- US interest rates.   All the dollars its buys in the foreign exchange market have to be invested somewhere.    That  means actually declaring that China is manipulating its exchange rate is rather risky.  

Tim Adams is clever.  He doesn't like his options.  He has been trying to convince the IMF to take a more active role in the exchange rate debate, so far without much success.   The IMF's timetable is not the Congressional timetable.  And now Adams seems to be trying to change the US bilateral game as well. 

If he can convince Congress that the Treasury should focus on exchange rate misalignments rather than on exchange rate manipulation, he potentially can avoid calling China a manipulator without losing credibility on the Hill.   Though I am not sure if Grassley-Baucus eliminates "manipulation" or just adds "misalignment" as an intermediate category.  UPDATE: Grassley/ Baucus would eliminate "manipulation."   Confirmed by a credible source.

Grassley-Baucus certainly would mean a lot more work for the Treasury: I suspect that there are a lot more misaligned exchange rates than manipulated exchange rates out there.  The yen looks a bit misaligned to me, even if the Bank of Japan isn't manipulating it.  Japan's growth has recovered, yet its real exchange rate remains quite weak.    The Argentine peso looks misaligned.    Almost all oil currencies look misaligned.  I don't particularly see why the Saudi Riyal has not appreciated in nominal terms since 1998 even as oil has surged.    And so on.

On the other hand the Economist - or at least those writing its China leaders -- doesn't seem to think that the RMB is misaligned at all.   The actual article on China's exchange rate is a bit better than the one-sided leader, though I still think it leaves some key facts out.

To be clear, China is not the sole source of the US current account deficit.   I don't think anyone in the US Treasury has suggested that it is.

A country with a GDP of only $2200b almost mathematically cannot be responsible for a current account deficit of $800b (for 2006, try a Chinese GDP of $2500 and US current account deficit of $950b).   Others have played a part.  The oil exporters have far bigger savings surpluses than China; their dollar pegs are also an impediment to effective balance of payments adjustment.   The US hasn't done anything to reduce its demand for the world's spare savings.  A smaller fiscal deficit would certainly help.

But one thing about the current world is a bit strange: a surge in the current account surplus of the big oil exporters hasn't led to a fall in the aggregate current account surplus of one of the world's most oil-intensive regions -- the manufacturing powerhouses of emerging Asia.  China's current account surplus increased in 2005 along with that of the oil exporters.

A growing current account surplus in the oil exporters and a constant (or even growing) current account surplus in oil importing emerging Asia necessarily implies a very large increase in the current account deficit of other oil importing regions.  

China also plays a far bigger role in the financing of the US current account deficit than its current account surplus alone suggests.  China may have provided up to ¼ ($200b) of the net financing needed to sustain its deficit in 2005.   It depends on how China invested its roughly $250b reserve increase (adjusting for valuation) in 2005. 

These are all things that I would think the Economist might want to mention. 

Maybe their distaste for the means the US Congress is employing to put pressure on China got in the way of their better judgement?  But I really don't quite see how the case for "openness" is enhanced by defending massive, sustained and one-sided intervention to keep the currency of a rapidly growing manufacturing powerhouse from appreciating.

The Economist's argument (and here, others are also guilty) that the rise in the US bilateral deficit with China has been offset by falling bilateral deficits with others in Asia also is a bit dated.

Let's look at those stubborn things.  Facts.

In 2000 - at the peak of the .com boom - the US imported $418 billion of goods from the "Pacific rim" (and $100b or so from China).  In 2005, the US imported $552 billion in goods from the Pacific Rim. 

Memo to the Economist: $552 is bigger than $418b. 

It is important to look at the other side of the trade ledger as well: US exports.   In 2000, the US exported $202b to the Pacific Rim; in 2005, $223b.    $21b isn't much of an increase relative to the $130b plus increase in imports.   Or by any other scale.  US exports to the sclerotic Eurozone went up by $21b over the same period, off a base that was only about ½ as big.   

Relative to US GDP, imports from the Pacific Rim are rising - not what one would expect if China is just displacing other Asian production.  And relative to US GDP, US goods exports to the Pacific Rim aren't doing much, something that perhaps the Economist might want to start noting as well.

Now, it is true that the end of the .com boom (and associated falls in the price of some electronic components) did lead US imports from the Pacific Rim to fall in 2001.    As a share of US GDP, imports from the Pacific Rim fell from 4.25% in 2000 to 3.75% in 2000.  But far too much analysis is stuck in 2003 and ignores the explosive growth in US imports from the Pacific Rim (driven by China) in 2004 and 2005.  Overall US imports from the Pacific Rim increased by 17.5% in 2004 and 12% in 2005, far faster than US GDP. That pushed US imports from the Pacific Rim to around 4.5% of US GDP in 2005.

And over the period when US imports have risen from 4.25% of GDP to 4.5% of US GDP, US exports have fallen from 2.05% of US GDP to 1.8% of US GDP. 

Since 2001 - arguably a better basis for comparison - US imports from the Pacific Rim have risen from 3.7% of US GDP to 4.5% of US GDP, and US exports to the Pacific Rim have stayed constant at 1.8% of US GDP.

Look at the following chart, which just forecasts 2005 trends out through 2006.

The Economist also makes much of a (small) reduction in the pace of China's export growth in 2005.   What it left out is that China's exports are still growing at a very, very fast pace.   I think the number 25% (the y/y increase in China's exports in January and February) should have appeared in the Economist's story for context.  Exports to the US are not quite growing as fast as China's overall exports, but the Economist might want to note that a 20% y/y increase off a $250b base also implies as large an absolute increase ($50b) as a 25% increase off a $200b base ($50b).  

More controversially, I don't fully buy the Economist's argument (derived I suspect from Roach) that so long as the US "saves too little" any change in the RMB or the imposition of tariffs would have essentially no impact on the US external deficit. 

This argument has two components, neither of which I find completely persuasive. 

The first is that higher tariffs would just lead production to migrate to other low-wage countries in Asia.  There is something to this argument.  It is one reason why I think a broad based appreciation in all Asian currencies set up off by further appreciation of the yuan is the best way to bring about the needed adjustment.  A stronger RMB also increases Chinese purchasing power, while a tariff doesn't.

But by the end of this year, the US will import about $300b from China and $600b from the Pacific Rim as a whole.   Supply chains cannot change over night.    In the short-run, I suspect a 30% tariff would imply that the US would still import $300b from China (probably more by 2007).  But US consumers would be forced to pay $390b for those goods, and the Treasury would get $90b in new revenue.  

And even over time, I doubt that all $300b in Chinese production would just migrate to Vietnam.   Some will, but some will migrate no matter what the US does as Chinese (coastal) wages rise.   And if lots of production does shift to Vietnam, the huge resulting inflow of capital would tend to push up Vietnam's currency -- unless Vietnam's central bank decided it wanted to replace China's central bank as the main source of financing to the US.   Talk about ironies of history.

That gets to the second assumption in the "tariffs will have no impact on the US deficit" argument: namely, that slapping tariffs on Chinese goods would not change the US savings deficit, China's savings surplus, or the world's willingness to finance the US savings deficit

I suspect a large tariff would have a small impact on the savings and investment balance.  Chinese firms might see their profit margins squeezed as their US business partners pressed them to offset the impact of the tariff.   Or US retailers/ US brands that assemble in their China might take a cut in their profits.   That would have some impact on business savings.  The US government will likely get $90b in new tax revenues.   US consumers  would have to either cut back on the consumption of other goods to keep on buying more expensive Chinese goods or dip even further into their savings.  My gut sense is that that the fall in government dissavings from higher tax revenues would more than offset the fall in consumer savings.

And then there is the delicate question of Chinese financing of the US.  A tariff might lead China to shift some of its reserves out of dollars.  Call it warning shot.  Though if China shifted into euros without changing its dollar peg, it would also drive the RMB down against the euro.  That would help Chinese exporters replace US sales with European sales ...

That would hardly make Europe happy.   More importantly, it might spook the markets - and make it hard for the US to finance its savings deficit at low rates.

A trade war is certainly not the best way to bring about adjustment, but it still would generate some adjustment.  

More generally, I suspect that a significant RMB appreciation -- and perhaps a tariff as well -- might lead both to a bigger bilateral US trade deficit with China and a smaller overall trade deficit.  US consumers would pay more for Chinese goods, but if a stronger RMB reduced China's savings surplus or cpaital inflows to China, reduced financing from China would also force the US to cut back on its consumption of all goods/ save a bit more/ invest a bit less.  

Too much analysis looks only at bilateral trade flows and takes the US savings deficit as a given; that ignores -- in my view -- the key role China plays financing the overall US savings deficit.

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