from Follow the Money

A trillion dollars doesn’t get the respect it used to …

September 8, 2006

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At least not from Dr. Cowen.

China will have a trillion dollars in reserves by the end of the year. A bit sooner actually -- a SAFE official recently indicated that China's reserves will top $1 trillion by the end of September.  China's reserves are growing by around $250b a year, despite the best efforts of China’s government to encourage (controlled) capital outflows and to discourage capital inflows.   If – as has been widely reported – China keeps about 70% of its reserves in dollars, China is adding around $175b to its dollar portfolio every year. 

China’s goods exports will likely reach $900b by the end of the year.  That isn’t quite a trillion, but it is about as much as the US exports (looking only at goods exports).   And even if China’s pace of export growth slows a bit (Chinese export growth to the world is currently is around 25% y/y), China is on track to export more than a trillion dollars worth of stuff next year.

Apparently, though, that isn’t enough to impress Dr. Cowen.    He writes: 

“China is neither our leading trade partner nor the leading foreign investor in the United States.”

Both of Dr. Cowen’s points are technically true, but I still think they paint a misleading picture of China’s impact on US markets.  Let me explain why. 

My earlier examples looked China’s overall exports and its overall reserve growth, not its flows to the US.   But even if we look just at flows with the US, I just don’t quite see how China emerges as a bit player.

Looking at “trade”  -- imports plus exports – is a bit deceptive in China’s case, since China buys very little (other than debt) from the US.    US goods exports to China will be maybe $55b this year.     And even if you look just at imports, between q2 2005 and q1 2006, the US imported more from Canada ($361b), and the European Union ($314b) than China ($252b).   But the US now buys more from China than Mexico ($181b).  And US imports from China are growing faster than US imports from any place else – at least any place else what doesn’t just sell oil. 

And if you look at global trade, China is in every sense now a superpower, exporting as many goods, more or less, as the US or Germany.

It is also true that on a stock basis, both Japan and Europe have more invested in the US.  They are, after all, much richer than China.  So Dr. Cowen is right to argue that – if you look at the total stock of foreign claims on the US, China isn’t the biggest foreign investor. 

But suppose we look at who is lending the US the most right now, rather than looking at who has the biggest accumulated stock of loans.  

I would argue that China tops that league table – no one is currently extending more new credit to the United States than China. 

The best data on Chinese inflows to the US that I have found comes from the US survey data – and the latest survey shows that China added around $186b to its portfolio of US securities between June 2004 and June 2005 (see p 13 of this Treasury publication).    I could bore you with the reasons why the survey data is probably better than the flow data in the TIC.   I won’t.    I will note that the survey data is very consistent with China’s reported 70% dollar allocation, while the TIC data isn’t.

China probably bought a bit less from June 2005 to June 2006 (the pace of its reserves growth slowed a bit after its July revaluation).   But it still likely is buying more than anyone else -- 

Collectively, the oil exporters may be buying more US debt – though they generally do their buying through London and don’t show up directly in the US data.  But I don’t think the Bank of Russia, the Saudi Monetary Agency and the Abu Dhabi investment authority are exactly market actors either ….

After noting that China isn’t the biggest investor in the US – and more generally, making the (true) point that the US deficit is much too big for even China to finance on its own --  Dr. Cowen argues that:   

“It would have to be the case that the dollar is significantly overvalued and that market prices, not just the pegged Asian exchange rates, are all wrong. ”

I do not know how closely Dr. Cowen follows the foreign exchange policies of the world’s emerging markets, but right now it seems that the dollar floats freely ONLY against other industrial countries.   Almost all emerging economies – whether soybean and iron exporters (Brazil), oil exporters (Russia) or manufacturing exporters (China) are intervening in the foreign exchange market to keep their currencies from appreciating against the dollar.  Just watch their reserves data.  

So yes, I do think that if emerging market central banks stopped spending $400-500b a year propping the dollar up, the dollar would likely fall against those currencies …   

Current "market" prices reflect unprecedented intervention by the central banks of the emerging world.

One last point; I am genuinely puzzled by the number of “conservative” economists that defend the government of China’s massive, sustained intervention in the foreign exchange market.   

No doubt, that intervention helps some in the US.  It also hurts others - a point Larry Lindsey recognizes in his Wall Street Journal article:

The matter of principle on which the American political process is now becoming focused is that it is the Chinese government, not our political process or the independent determination of markets, that is determining the result. We are buying more tee shirts, shoes and appliances and living in larger homes than we otherwise would because of a Chinese government decision. We are producing fewer appliances and less agricultural output than the market would have us make as well, thanks to a decision by the Chinese government. It does no good to tell American politicians that if the Chinese want to subsidize us we should let them, because the very fact of their subsidy changes our behavior in a way determined by them, not by us. 

I generally thought conservative economists believed in letting the market – not China’s central bank – shape the composition of US output.  The US may not have an industrial policy.   But China’s government indirectly has had a “US residential housing” policy.  Look at the scale of China’s recent purchases of US agency bonds (there is a graph showing the composition of China’s portfolio, with an estimate for what has happened after June 2005, in my testimony).   

I don’t see why conservatives should like foreign government support for the US housing sector any more than they like US government support for say the auto sector. 

That said, I would be the last to underestimate the challenges associated with changing the current global financial system, one where the US borrows and spends and the Asia (and the oil exporters) make (or pump) and lend.  I just don’t see how delay makes change any easier.

Call me an eat-your-spinach kind of guy.

p.s. knzn is worth reading.

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