- Blog Post
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The RMB has appreciated by about 7% against one of China’s major trading partners this year. Not the US, obviously. But that doesn’t mean that China is not exposed to moves in the dollar-euro, or the dollar-yen.
Indeed, right now, it looks like the RMB will move far more against the euro than against the dollar in 2005, even if China makes some small changes in the dollar-RMB peg over the summer.
There are plenty of reasons for the dollar’s rally v. the euro -- the upcoming French referendum on the new EU constitution, obvious signs that growth is slowing in Europe, rising policy interest rates in the US and constant policy rates in Europe, and the unwinding of some dollar funded carry trades. For now, "cyclical" concerns trump "structural concerns" about the US trade and current account deficit. Fair enough. Credit is owned where credit is due: so far, Stephen "Current account deficits don’t matter" Jen has been directionally right. He also thinks fair value for the euro dollar is closer to 1.1 than to 1.25 (Jen’s longstanding view), so he thinks the dollar has room to rise a lot further ...
The dollar’s rally -- and low long-term US interest rates -- still worries me. I would be more comfortable if the dollar was depreciating against non-European currencies and holding constant against the euro, widening the base dollar depreciation. And yes, I also would prefer to see a slow rise in long-term US rates.
The world seems to be slipping back towards the growth pattern that everyone is most familiar with -- growth driven fundamentally by surging US demand, supported by rising US real estate prices. China contributed substantially to global demand growth too in 2003 and 2004, particularly in some commodity markets. But Chinese import growth has slowed this year. Right now, China, like everyone else, depends on the US consumer.
What’s wrong with this? This pattern of growth presumes growing global imbalances -- i.e. an expanding US trade deficit. And it will result in growing domestic imbalances in the US. A real-estate centric economy will become more real-estate centric. If the dollar rally continues, the market incentives to invest in the US tradables sector will fall -- yet that export capacity is what the United States needs to grow out of its trade deficit by growing its exports (It should be noted that the dollar has depreciated against the Brazilian real and Korean won this year, even as it has appreciated against the Euro, limiting the dollar’s overall appreciation).
In the short-run, there are advantages to continuing the current pattern of growth. It is far easier for the growing sectors in the world economy -- real-estate in the US, exports in China -- to keep on growing than to find a new basis for growth. But it also adds to the risk of a hard landing further down the line. To me, the soft landing scenario requires market pressures to slowly emerge to change, gradually, the composition of US growth: a falling dollar increases incentives to export, and to invest in export sectors; rising interest rates reduced the incentive to bet on rising housing prices, and make it harder to cash out home equity. The reverse would happen abroad: slowing demand growth in the US and the drag of a weak dollar would prompt other countries to focus on stimulating domestic consumption. Alas, that, by and large, hasn’t happened.
Why does the euro-dollar matter in all this? Simple. The fall in the dollar against the euro through the end of 2004 has been an important source of support US exports. It is easiest to see in US-Europe data, but it is also important to remember that US product also compete with European products for sales in third party markets. Think GE v. Siemens in China, or Boeing v. Airbus in India. But let’s just look at bilateral trade between US and Europe. Asia may be booming -- but US exports to Asia are not. In q1, US exports to the Asian Pacific region were basically flat, up only 1.6% y/y (US exports to China: $9 b in the first quarter of 04, and $9 b in the first quarter of 05). By contrast, US exports to the euro zone are up 8.5% (q1 data, y/y), US exports to "old Europe" (France, Germany, Italy and the Netherlands, which is the port for much of old Europe) are up even more (11.5%). US exports to Europe also grew nicely in 04 -- they were up 14% y/y; more than the 11% increase in US exports to the Pacific Rim. (Data all comes from the BEA)
If the dollar’s rally is sustained, expect that growth to slow -- slowing growth in Europe plus a stronger dollar is not a good recipe for export growth. A sustained dollar rally will also reduce the incentive for European exporters to shift production to the US to offset the drag of a strong euro. I increasingly suspect that both US export and non-oil import growth rates will slow from their q1 pace, but non-oil import growth in the US will far outpace export growth, leading the trade deficit to keep on growing (falling oil helps a bit). Something like 10% y/y growth in non-oil imports, and 5% growth in exports seems increasingly plausible ... That leads to a roughly $750 b US trade deficit, and a current account deficit of close to $850 b.
Incidentally, I don’t think the (formerly) strong euro bears all of the blame for Europe’s current slowdown. Why? Because it has not put much of a dent in US imports from Europe -- they are up 8.5% y/y in the first quarter, and were up 12% y/y in 2004. All higher prices and no increase in volumes, you might say. But the data doesn’t bear that out. As Alan Greenspan has noted, most European producers have just accepted lower profit margins ...
Want a surprising stat? Europe’s exports to the US have grown 28.5% between 2000 and 2004 -- even with the euro’s rise since 02. Nothing compared to China, whose exports to the US increased by 97% between 2000 and 2004. But European exports to the US still grew faster than overall Asian Pacific exports to the US -- which were up only 18% over the same period.
Part of that is the lagged impact of the weak euro, which lasted til mid 2002. US imports from the Asian-Pacific region are currently growing twice as fast as imports from the eurozone. (15.6% v 8.4% --yes, exchange rates do matter ... )
One thing that has puzzled me, given strong US productivity growth and lagging productivity growth in Europe, is why US exports have not done better relative to European exports. Overall US goods exports have grown by about 4.5% since 2000, overall exports of US goods and services are up only 7%.
That is not very impressive. Obviously, the much faster growth in Europe’s exports to the US than US exports to the world (or US exports to Europe, which were up 9% between 2000 and 2004) reflects faster demand growth in the US than in Europe, if not the world. But it also suggests to me that the productivity gap between the US export sector and Europe’s export sector may not be all that large. David Altig of Macroblog has drawn attention to Martin Wolf’s charts showing the gap between productivity growth in the US and Europe since 2000.
I was more struck my the graph on export growth. After booming in 99 and 2000, French and Italian export growth looks kind of American. German exports, though, have continued to do very well. My sense is that productivity is higher in the German auto sector than the in the US auto sector ...
One last point. Remember how valuation gains (Gourinchas-Rey effects ... ) on existing overseas assets can offset the growing liabilities associated with ongoing trade deficits? Valuation gains linked in large part to the dollar’s fall to 1.35 against the euro during 2004 supposedly will take about $400 b, maybe a bit more, off the end 2004 US net international investment position. Almost all of those valuation gains, more or less, have now been lost. If the dollar holds at 1.25/1.26 through the end of 2005, the 2005 net international investment position of the US will show a $800 b plus deterioration from the 2005 current account deficit, AND maybe a $300b valuation loss on US investment abroad, leading US net external debt to surge to around $4 trillion (over 30% of US GDP). Gourinchas-Rey works both ways. Alas, we don’t yet have the 2004 NIIP; the 2005 NIIP won’t be reported until mid-2006 ...