from Follow the Money

The world’s two most distorted prices …

December 18, 2004

Blog Post

My nominations.

The renminbi-dollar at 8.28 renminbi per dollar -- a price that puts China’s per capita income at around, only a bit above Iraq’s per capita income.

The ten year US government treasury bond, which now yields roughly 4.25% ten year Treasury. US inflation this year was around 3%, a bit higher than most expected. The dollar fell against a range of currencies -- and there are (legitimate) expectations that it will fall further. Are domestic investors being compensated for the risk of future inflation? Are foreign investors compensated for the risk of further depreciation? At least for foreign investors, the answer is clearly no.

The renminbi is too low; the ten Treasury is too high (therefore its yield is too low). The two are related, of course -- the weak renminbi spawns reserve accumulation in China and all Asian economies that peg to the renminbi-dollar, and even countries that don’t peg often intervene to avoid seeing their currency appreciate against the renminbi-dollar. Those reserves and invested in US bonds, Treasuries as well as Agencies.

Unfortunately, both distorted prices are leading to potentially dangerous decisions.

First the ten year Treasury.

The low price of the ten year seems to have convinced US policy makers that government borrowing doesn’t matter. They no longer say deficits don’t matter -- but they act as if they don’t. There is no way partial privatization of social security can go ahead without a surge in government borrowing, on-budget or off. We will see if the President is serious about cutting non-defense discretionary spending enough to cut the deficit in half -- the required cuts are large, since there is not that much non-defense, non-homeland security discretionary spending -- or if he is serious about making the Republican congress take the blame for over-spending (relatively to an unrealistic baseline).

All in all, low interest rates on long-term borrowing are leading our "debt" society to go ever deeper into debt, and to keep on spending more than we produce. In 2004, growing US imports added $280 billion in demand to the world economy -- not a small sum. Our propensity to borrow -- and our creditors willingness to indulge us at low rates -- makes us the engine of global consumption.

The distortions created by the artificially weak renminbi are equally profound. China’s investment in its export sector is surging. Investment rose to something like 47% of China’s GDP this year -- and a large share of that investment is going into building more capacity to export. China’s exports to the US look set to grow by 28% this year. By the end of the year, china will be exporting roughly $200 billion a year to the US (using US import data, Chinese export data show smaller exports; I trust the US data). Forecast out 25% growth -- in three years, by 2007, China’s exports to the US will be close to $400 billion, and over 20% of China’s GDP. That is as much (relative to GDP) as Mexico exports to the US, and China is not quite as close to the US as Mexico. Germany exports more like 3% of its GDP to the US. Even if US exports to China keep growing at a 30% clip (hard, if China’s does not want to buy more boeings next year), the trade deficit will balloon from @$150 billion to $300 billion ... Keeping the US global trade deficit constant in that context would require the rest of the world’s trade surplus with the US to shrink by about by about a third -- from $450 billion to $300 billion.

I don’t think it is realistic to think that US imports from china will double over the next three years, particularly if that expansion -- of a now large base -- implies big time pain for other exporters. It would be easier for China’s exports to the US to keep on expanding, of course, if China is willing to finance an expansion of the US trade deficit -- and thus to defer the United States day of reckoning. But that means China is just storing up bigger losses when the renminbi-dollar changes -- losses on its foreign exchange reserves, and real losses when its export sector takes a hit once the US cannot keep on buying at its current pace.

Current investment in china’s export sector is premised on a continuation of current trends: A US that keeps on importing way more than it exports, a US import market that keeps on growing faster than US export markets, and a growing Chinese share of the overall market. All are unlikely to all come true. China is just too big now -- its actions have to big an impact on the overall global balance.

The problem with keeping the current exchange rate regime -- or something close to it -- is that it leaves the US with too many McMansions, too much household debt, way too much government debt and too few export industries, and it will leave China with too many factories built to serve a US market that simply cannot keep expanding at its current rate.

Robert Samuelson is right: the future is not likely to look like the past. The US expansion fueled by falling interest rates (and rising asset prices) has run its course. Over the next ten years, sectors that can export are likely to grow faster than sectors that do not ... as counter-intuitive as that sounds.

Brad de Long is also right: the shift in resources required to move from an US economy based on exporting debt (to East Asia) to an economy based on exporting goods and services will be enormous. The sectors that expand along with debt exports are not the sectors that have to expand to grow goods and services exports. The US economy is more flexible than Europe’s. US workers move around more. But we also don’t have much experience moving resources in exporting industries -- and out of the interest-sensitive industries favored by East Asia’s interest rate subsidy. The basic trend over the past twenty years has been for resources (labor, capital) to flow out of manufacturing sectors.

The same can be said for China: we can only hope that the factories built for export markets can be converted to serve a growing Chinese market -- and that the government of China has the policy tools needed to engineer a sudden surge in Chinese demand should US demand falter.

The Indian Ocean tsunami caused such destruction in some fundamental sense, for two reasons. First, the plate under the Indian ocean is sliding under the plate of the earth’s crust that is Indonesia (at least Sumatra and Java) -- but sometimes a bit of the plate snags and lags behind the rest of the earth’s crust, leading pressure to build up until it explodes (so to speak) in a massive quake. Second, there was no system in place to warn those on the other side of the Indian Ocean (Sri Lanka) of the quake off the coast of Sumatra.

The imbalanced relationship between the US and emerging Asia need not give rise to an economic tsunami. It is still not to late to find ways to diffuse the pressure before it builds up to such a high level that the system quakes. An Asian plaza might be a good place to start -- with the US agreeing to take steps to reduce its need for financing. But acting preemptively -- and taking pain now -- to ward off future trouble is always extremely hard; and there is little evidence the world has much appetite for it.