from Follow the Money

Some things I got (more or less) right

December 31, 2005

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Unfortunately, this list is a bit shorter than the list of things I got wrong. 

Still, I think my crystal ball got a few things right.

  1. The rise in China's current account surplus.  I - influenced by Morris Goldstein  -- thought China's surplus was poised to expand dramatically in 2005.  It did.  No one can now argue that China's surplus with the US (and Europe) is offset by its deficit with the rest of the world.  It is not.  China runs a current account surplus that is roughly comparable in size (when assessed relative to China's GDP) to the deficit of the United States.  China's surplus will be above 6% of its (revised) GDP in 2005, and the US deficit will be above 6% of US GDP as well.  
  2. China would emerge as the true anchor of Bretton Woods 2, and would be forced to provide ever-more financing to the US.    That still seems right.  The pace of China's reserve accumulation increased in 2005.  Adjusting for roughly $30 billion in estimated valuation losses and the transfer of $15 billion in reserves to one of China's state banks, I suspect China will have added close to $250 billion to its reserves in 2005.  Maybe more if the small November reserve increase reflects the PBoC's currency swap, not a big fall off in capital inflows. $250 billion is up from the $185 billion or so China added to its reserves in 2004 (assuming that valuation gains accounted for about $15 billion of the $200 billion "headline" increase in China's reserves). Chinanow accounts for roughly ½ of global reserve accumulation, up from maybe 1/3 in 2004 and a bit over a quarter in 2003. 
  3. At least some in China don't think it makes sense for China to keep on adding to its dollar reserves at its current pace.  They worry that the United States' large trade deficit suggests the dollar is likely to fall in value over time.   Given that a large share of China's national savings is now invested in dollars, a fall in the dollar relative to the RMB (or the euro relative to the RMB) would reduce Chinese wealth.  China's central bank understands this, probably better than anyone else. Professor Yu Yongding has made that clear (hat tip: Steve Hsu).  The PBoC has good reason to fret: they have issued RMB debt (and RMB) cash against China's dollar and euro reserves.   Chinese savers want RMB, not dollars.  So do lots of other folk.  
  4. Petrodollars are really petrodollars.  I am going out on a bit of a limb here, since we still don't really know.   The core message of the most recent BIS quarterly report is not that the oil states are showing a stronger preference for dollars, but rather that the data collected by the BIS from the world's banks only tells us the currency composition of a tiny fraction of the oil states' external assets.  But I think most people do believe that the oil sheiks are providing some financing of the US, though in ways that do not show up in the US data.  When the final tally comes in, I suspect that the oil states will be the source of 40% of the world's current account surplus in 2005, and the US something like 80% of the world's deficit.   So I'll put it this way: the roughly $400 billion current account surplus of the world's oil exporters exceeds the combined current account deficit of the countries outside the US that have deficits (treating the euro area as a single unit), so the global current account only adds up if the oil states are financing the US in some way, directly or indirectly. 
  5. The US trade and current account deficit did not peak in early 2005.  Alan Greenspan thought he detected incipient market pressures for adjustment back in March.  The Maestro's call now looks just a bit off.   Even then, the market pressures for adjustment were limited - they were present in the euro/dollar, but not in many other currency pairs or in the bond market.  And almost as soon as Greenspan detected these pressures for adjustment, they started to disappear.  The q4 2005 US current account deficit is likely to come in at close to 7% of US GDP, a new record.    The overall 2005 current account deficit will come in a bit over 6.5% of US GDP - up from 5.7% in 2004.

The large q4 current account deficit is one reason I am fairly confident that the US current account deficit will continue to expand in 2006.   The q4  2005 current account deficit is likely to come in at $225 billion, if not a bit more.  Annualized, that implies a $900 billion current account deficit.  And I expect the 2006 US current account deficit will be a bit bigger than that. 

Remember, rising interest payments will push the current account deficit up even if the trade deficit stabilizes.   I would be shocked if (net) interest payments do not add more than $50 billion to the US current account deficit in 2006.  And I also suspect the trade deficit has not peaked either - at least not in dollar terms.   On this, I disagree with Calculated Risk.  

The euro/ $ and yen/ $ are not the only factors that drive the US trade deficit - far from it.  One of my pet peeves to is to equate the dollar with the dollar/ euro.   Bringing the trade deficit down will require a far broader set of global adjustments: the currencies of emerging Asia need to appreciate against the dollar, consumption growth in the US needs to slow, consumption growth in China needs to pick up and, if oil prices do not fall, the oil states need to consume more too.  But the euro/$ and the yen/ $ do matter - US made goods compete with goods from Europe and Japan in a range of markets, not just in the US.  And the dollar's rise against the euro and yen in 2005 should start to slow US export growth in 2006.   

And even if Calculated Risk is right and a housing slowdown starts to drag down the pace of US consumption growth, I doubt it will drag non-oil import growth down enough to prevent the trade deficit from rising.   Right now, a number of signs (October US import data, October and November trade data from China and Korea) suggest that the US inventory correction is over, and non-oil imports are ticking up -- that is what one would exect.  US imports recently have tended to grow about twice as fast as US consumption growth.   Above all, though, the math is just daunting.  Exports have to grow 60% faster than imports, more or less, just to keep the trade deficit stable.

The big wildcard: oil.  A big fall in the price of oil might lower the US deficit significantly -- maybe even by enough to offset the expected rise in interest payments.  But a big fall would presumably need a big trigger.

The hard question is not whether the US trade deficit will expand next year - barring a shock early in the new year, I am confident that it will, at least on a year over year basis.   The hard question is whether or not the trade deficit will peak next year.   The hard landing scenario that Nouriel and I laid out suggests it could, but only if the US economy slows substantially. 

I still think the risk of a hard landing is far too high. But at this point, I would not bet on a hard landing in 2006.  And for all my warnings of doom and gloom, this is one forecast I would rather not see come true.  Hard landings are not fun.   But I certainly would like to see stronger signs that the policy adjustments -- and yes, the orderly market moves -- needed to bring about a nice soft landing are beginning to take shape.  

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