from Follow the Money

There is currently a shortfall in Chinese demand for the world’s goods, not Chinese demand for the world’s bonds

January 27, 2009

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The tone of some recent commentary on the Sino-American relationship almost suggests that the US is so reliant on Chinese financing that it should be encouraging China to devalue the RMB to increase China’s current account surplus – and thus its capacity to finance the US deficit. Presumably it should encourage China to limit its fiscal stimulus too, so as to better assure the financing the US needs to sustain the large increase in its fiscal deficit. The last thing the US should want is any policy change that might, well, increase Chinese demand for the world’s goods. The risk that this would reduce China’s demand for America’s bonds is too great.

I disagree.

Right now the global economy is short of demand for goods, not short of demand for government bonds. The expected rise in the US fiscal deficit does not imply a rise in the current account deficit when private demand is contracting. It thus doesn’t imply any increase in the United States need for external financing, at least not in the short-run. The more China does to support global demand, the better – even if thus means a fall in China’s current account surplus and a gradual fall in Chinese demand for foreign assets. If a strong Chinese stimulus ends up supporting the global economy - and net exports help to pull the US out its slump -- all the better.

Let’s go through several key points in more detail:

The core problem in the global economy is a shortage of demand for goods, not a shortfall in demand for safe government bonds

The collapse in global trade recently has been absolutely stunning. Exports are down over 20% in a host of Asian economies. China is actually doing comparatively well. Its exports so far have fallen less than Korea’s exports, Taiwan’s exports and Japan’s exports. Global output is falling.

Treasury yields have moved up a bit recently. But they remain well below their levels in say last September. The fact that yields have fallen even as the amount of bonds the G-7 countries are trying to sell into the market has soared suggests that there has been a large increase in demand for government bonds.

This could change, of course. But right now the global data suggests a sharp fall in output – not a sharp fall in demand for bonds or a rise in the risk of inflation. More demand for the world’s goods should be welcomed.

A rise in the fiscal deficit -- under current conditions – does not necessarily imply a rise in the current account deficit, or a rise in the United States need for foreign financing.

This point isn’t universally accepted. Willem Buiter, for example, argues that the US should be cutting spending not increasing it – as any increase in the fiscal deficit would feed into a dangerous increase in the external deficit.

"The US is proposing policy measures that will increase its external deficit. The $825bn fiscal stimulus over two years proposed by the Obama administration will increase the US current account deficit. It will also strengthen the real effective exchange rate of the US dollar, unless there is a loss of faith in the ability of the US sovereign to service its debt in the future through higher taxes or lower public spending. ... The last thing the US economy needs is a large fiscal stimulus, or indeed any fiscal stimulus at all. A good argument can even be made for a US fiscal tightening. Expansionary monetary policy is the only instrument available to the authorities that will both boost the US economy and correct its external imbalance.

Buiter is of course right that absent a counter-cyclical fiscal expansion, the current account deficit would contract faster. But it isn’t the case that the fiscal expansion necessarily implies an expansion of the United States external deficit. That is only the case if private spending and investment are constant. Then the rise in the fiscal deficit feeds directly into a rise in the current account deficit (or puts upward pressure on interest rates, which leads to a fall in private investment and a rise in private savings to free up funds to finance the fiscal deficit). Right now, though, a host of indicators suggest that private spending and investment isn’t just contracting, but it is contracting faster than the fiscal deficit is rising.

The trade deficit is a good proxy for the current account deficit (the income surplus and the transfers deficit offset). And it fell in the fourth quarter. Calculated Risk expects it to fall further in January based on the fall in oil prices. I agree. A $30 billion monthly trade deficit works out to an annual trade deficit of $360 billion – or well under 3% of US GDP. The deficit in the fourth quarter won’t be quite that small. But the current account deficit certainly fell in the fourth quarter even as the fiscal deficit rose.

Don’t get me wrong. I worry that the rest of the world will rely too heavily on the US to stimulate domestic demand and that the US alone will have to try to pull the global economy out of its current stall, with an associated rise in both the US current account deficit and foreign demand for US treasuries. This scenario implies that the US stimulus would eventually produce an expansion of US demand for imports and the more modest stimulus abroad wouldn’t generate a comparable demand for US exports, so the US deficit would rise.

There is also a risk that the fiscal stimulus will be bigger than the what the US needs, as the contraction in private demand will prove smaller than forecast. Up until now though the error policy makers have made is that they have underestimated the power of the contractionary forces in the global economy …

Right now though the United States external deficit is falling even as the fiscal deficit is rising. That can happen because private savings is rising. Merrill’s David Rosenberg recently observed “As it becomes increasingly apparent that the $13 trillion (and counting) loss of household net worth in this cycle is not coming back, look for the savings rate to head back to the Ozzie and Harriet levels of 10 to 12%.” Private investment is also falling. Unless something changes (and much could change, starting with the price of oil), the 2009 US fiscal deficit will be north of 8% of US GDP and the 2009 US current account deficit will be around 4% of US GDP.

A Chinese fiscal stimulus means less Chinese demand for US bonds

This stands to reason: the more China spends at home, the less it has to lend to the US.

But that too simple. Chinese demand for US financial assets (really the world’s financial assets) is a function of China’s current account surplus. More government spending only reduces Chinese demand for foreign assets if the spending lead to a fall in China’s external surplus. And that won’t happen if the rise in spending offsets a contraction in private demand. Private investment is currently falling in China. Unless private savings is also falling, the fall in investment would mean a bigger current account surplus and MORE Chinese demand for foreign assets. A bigger fiscal stimulus might just limit the increase in China’s surplus.

There is also a sense that the US doesn’t benefit if China spends more domestically, so the US loses access to cheap financing without getting anything in return. But that isn’t true. The fiscal stimulus only reduces Chinese demand for foreign assets if China ends up running a smaller current account surplus. That means more Chinese imports. And more Chinese demand for the world’s goods helps those in the US who make goods. The trade off isn’t between more domestic spending and more Chinese purchases of Treasuries: it is between Chinese purchases of Boeings and Chinese purchase of Treasuries.* China’s export revenue ultimately has to be spent abroad, whether on foreign assets or foreign goods.

A fall in Chinese reserve growth means less Chinese demand for foreign assets.

This would be true if the fall in reserve growth reflected a decision to let the RMB appreciate and a fall in China’s current account surplus.

But it isn’t true if the fall in reserve growth reflects a rise in private capital outflows rather than a fall in the current account surplus.

China’s total demand for the world’s financial assets is ultimately a function of its current account surplus (which, by identity, is the same as the amount that China saves that it doesn’t invest at home). If reserve growth falls even as the current account surplus rises, net Chinese demand for foreign assets is doing up not down. The demand is just coming from private Chinese investors.

The common perception that China has to finance the United States and Europe’s large fiscal deficits doesn’t add up. The GDP of the US and the EU, combined, is something like $30 trillion (the precise sum depends on the exchange rate). They collectively will likely run a fiscal deficit of between 5 and 10% of their GDP. That works out in very rough terms to a deficit of between $1.5 trillion and $3 trillion. China is a roughly $4 trillion dollar economy with a 10% of GDP current account surplus .... or about $400 billion to lend to the world. Barring huge change, China simply isn’t big enough to finance the kind of deficits now observed in the US and Europe. Those big deficits have to be financed internally.

Then, of course, they are the set of loaded questions surrounding China’s exchange rate regime ...

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