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Jen v. Setser on exchange rates and global adjustment

March 16, 2007

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It is fair to say that I see the world very differently than Dr. Jen.  He thinks imbalances are a natural byproduct of globalization.    I think they are a natural byproduct of undervalued exchange ratesin the emerging world and Japan and massive growth in the emerging world’s official assets.

He interprets the fall in the q4 current account deficit as evidence that exchange rates don’t matter, and thus there is little need for the dollar to move more.    A rise in the US savings rate triggered by the housing retrenchment is all that is needed.  He wrote in his weekly note: 

“The sharp drop in the US C/A deficit in 4Q was a validation of the benefits of a world rebalancing through income, rather than through exchange rates.”

I, by contrast, interpret recent data as evidence that exchange rates do matter – not the least the exchange rate between the dollar and a barrel of oil.   

The fall in the dollar cost of oil was the biggest reason for the fall of the q4 current account deficit.   But it wasn’t the only reason.  US export growth has been strong since 2004.   Why?  Probably because of the lagged impact of the dollar’s 2002-04 fall. And when I look at the regional data, I see even more evidence that exchange rates matter.   

regional_balance_smaller
 

Both Asia and Europe grew strongly in 2006 -- i agree with Jen on one point, there was a "rebalancing" of the sources of global growth in 2006.   

The US current account deficit with Asia, though, is still rising, while the deficit with Europe and the NAFTA countries is heading down. Why?  Presumably because European currencies – and the loonie – have appreciated, while Asia has resisted currency appreciation.     

This pattern – adjustment with Canada and Europe, but not with Asia – was quite apparent in the monthly trade data as well.

The January data adds to the growing body of evidence suggesting that non-oil imports really did stall in the second half of 2006 as US growth slowed.  Non-oil goods imports have been stuck around $131b a month since June.  January 2007 non-oil goods imports were only 2% higher than January 2006 non-oil goods imports.   That trend – if sustained – does set the stage for a reduction in the trade deficit so long as oil stays where it is and growth outside the US remains strong.   The evolution of the broader current account balance though depends on the income as well as the trade balance.

So what explains the fall in the pace of non-oil import growth?   A fall in the pace of growth from China?  Not really.  US imports from China are still growing at a 20% y/y clip.  Overall US imports from the Asia-Pacific are up by around 12% -- i.e. they are rising as a share of GDP.    US exports are doing quite well in Asia, but the US trade deficit with Asia is still rising.    

What of old Europe?  US imports from Europe writ large were by up a bit less than 3% y/y in January; those from the eurozone are up a bit more, but at 4.5% they aren’t growing all that fast either.   The US trade deficit with Europe is falling.  

And then there is Canada.  It is clear that the combination of a slumping housing sector (think lumber), a slumping US auto sector (think how close Detroit is to Canada) and a relatively strong Canadian dollar are having a rather significant impact.  US imports from Canada in January 2007 were about 6% below what they were in January 2006.   December 2006 imports were 10% lower than December 2005 imports. 

The main reason why overall non-oil imports haven’t been growing is simple: Non-oil imports from Canada have plummeted, offsetting the rise in non-oil imports from Asia.

What of the export side?   Well, exports to Asia are growing at a decent rate, as one would expect given strong Asian growth.  But given the huge gap between what the US imports from Asia and what it exports, they are not nearly fast enough to keep the deficit from rising.    Europe isn’t growing as fast as Asia, but US exports to Europe are really booming.   The January y/y growth numbers were out of the world –US exports to the EU were up 29% on a y/y basis in January.   The monthly data isn’t seasonally adjusted and can be influenced by the timing of various holidays and the like, so that growth pace seems a bit too high.   But the December growth rates were also solid – 17%.    Europe is doing its part.  Its current account deficit is falling because of a falling oil bill and rising exports to the oil states.  Its surplus with the US is shrinking.

The basic story is consistent.  The US deficit with Canada and Europe is heading down, the US deficit with Asia is rising.   So tell me again why exchange rates don’t matter?

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