Economics

CATO’s Dorn attacks a coordinated policy response to global imbalances on the grounds that it presumes that governments have a better sense of the “right” exchange rate than the markets: A negotiated approach to resolving trade imbalances presumes that “experts” know the relevant market-clearing exchange rates and that governments can agree to enforce them – neither of which has proved to be true. Any exchange rate that was fundamentally misaligned would eventually be attacked and governments would be ill-equipped to prevent it. Moreover, the longer that adjustment was delayed, the higher the cost would be in terms of resource misallocation. But doesn’t the current system hinge on “experts” rather than markets setting key exchange rates?   In this case, the key experts are China’s State Council (which seems to make Chinese exchange rate policy), the central banks of the GCC countries and the heads of all the other emerging market economies intervening in the fx market at an unprecedented rate.  And hasn’t a key lesson of the past few years been that governments are a bit more able to ward off attacks if they are defending an undervalued exchange rate than if they are defending an overvalued exchange rate?   Particularly if they have somewhat effective capital controls in place ...   And, viewed, from Dorn’s perspective, doesn’t delaying the end of the current system  only increase the misallocation of resources created by central banks massive intervention in markets and the resulting deviation of key exchange rates from market levels?It seems to me that a big part case for policy coordination is precisely that current emerging market exchange rates are so far from market clearing exchange rates – look at the current scale of reserve accumulation in the emerging world – that any changes needs to be both gradual and coordinated.   Ending the United States bond markets dependence on its central bank fix by going cold turkey wouldn’t be fun.    Another part of the argument for coordination is that absent a bit of coordination, everyone will continue intervening at the current – or perhaps an even bigger rate.  Coordination is needed to convince folks to change.  And a final part of the argument for coordination is that adjustment would be a lot easier if everyone was confident that steps to reign in US demand growth were matched by steps to spur demand growth outside the US.    See Larry Summers.

Call me old fashioned, but isn't a rising trade surplus -- driven by strong exports -- a rather natural result of a weak currency?    The yen is super-weak v the euro and weak v. the dollar.   And it has been rather clear than Japanese car companies are gaining market share here in the US .... Strong September export growth from both Japan and China suggests that the US continued to snap up a lot of imports in September.  And continued strong export growth, rising interest income on Japanese and Chinese holdings of US debt and -- eventually -- a somewhat lower oil import bill -- all suggest a rise in East Asia's current account surplus.

I would be the first to concede that $60 isn't $80.  Or even $70, the average price for oil (at least the good sweet light easy to refine stuff) in the second and third quarter.   US consumers - at least those in those parts of the income distribution that haven't seen big rises in their nominal-let-alone real wages -- were starting to feel really squeezed with oil at $80.  Now, they can afford to fill up their tank and still buy at least a few things at the local Walmart.But the premise behind Chip Cummins' A2 Wall Street Journal article still seemed a bit off.  If you invested in a lot of oil fields that were expected to be profitable if oil averaged $20 a barrel, you will certainly make more money if oil is at $80 -- or even $70 -- than if oil is at $60.   But I am pretty sure that you will be making money even if oil is hovering around $60 a barrel.Equity markets are not my thing.  But given the change in the trajectory of oil prices, I cannot imagine that anyone holding an oil companies' stock would expect oil companies to be able to sustain the kind of revenue growth they enjoyed when oil was steadily climbing up now that oil is falling.   So, unlike Cummins, I would hardly define a slowdown in oil profits as a "big problem":"With crude prices falling and oil-field costs on the rise, major oil companies have a big problem: sustaining their phenomenal profit growth." Oil companies should make less money in q4 than in q3.  So what?  They will still be making a ton of money.The same basic logic applies to most oil exporting countries.  They aren't going to be quite as flush with cash as they were in q2 or q3.  But they will still be very flush.   Any oil exporter that faces financial difficulties with oil at $60 has done a terrible job of managing the oil windfall.  I have long thought that most oil exporters were a bit too conservative with their budgets -- as many were still budgeting for oil at $25-30.  But there is a still a big difference between $30 and $60.  $60 is still, I think, higher than the average oil price in 2005.   Indeed, if someone had told me two years ago that oil at $60 would be widely considered a positive for the US economy (and a negative for oil companies), I wouldn't have believed them.   Then again, if someone had told me two years ago that China could double its reserves, only partially sterilize the resulting reserve increase and still have (CPI) inflation of less than 2%, I wouldn't have believed them either.Oil companies -- at least private oil companies in the US and Europe -- do face a big future problem.  It isn't oil at $60.  It is that they aren't likely to be able to replace their existing oil fields -- oil fields that generally were developed with the expectation that oil's long-term price was well below $60 -- with comparably cheap fields.   Oil fields that were meant to turn a profit if oil averaged $20 will need to be replaced by oil fields that will only turn a profit is oil is well above $20.   Hey, that's life.   No country with oil should be selling their oil forward at that low a price right now.   See James Hamilton over at EconBrowser.

Francophone economist working in the US seem to be on something of a roll.   Olivier Blanchard (with Giavazzi and Sa) has developed an interesting model for US current account adjustment.  Helene Rey and Pierre-Olivier Gourinchas have incorporated the fact that dollar depreciation helps the US external position by increasing the dollar value of US external assets into their model for the dollar's value.   Being French, they emphasize the advantages of the United States' “exorbitant privilege.”   Being sane, they realize that a bit of exorbitant privilege doesn’t make a 6-7% of GDP trade and transfers deficit sustainable forever. Olivier Jeanne and Romain Ranciere’s model for reserve adequacy strikes me as equally important.  Their model can help to determine how many reserves emerging economies need to protect against the risk that a sudden stop in capital flows will lead to a sharp crisis.  The current reserves of emerging economies can then be compared with the level predicted by the model.  That is one way of determining who has too few reserves -- and who has too many.    Their conclusions are eminently reasonable.  More public debt creates more need for reserves.  Balance sheet mismatches – something that Jeanne and Ranciere proxy using the ratio of foreign liabilities to money in the banking sector -- create more need for reserves. An over-valued exchange rate creates the need for more reserves.   Capital account integration increases the need for reserves.   That was the (hard) lesson of the 1990s.    So an emerging economies with lots of public debt, a heavily dollarized banking system, an open capital accout and an overvalued exchange rate (Argentina, circa 2000) really, really need reserves.      Jeanne and Ranciere determined that countries generally need more reserves than called for by the Guidotti-Greenspan rule (hold reserves equal to your short-term external debt) to limit the risk of a crisis.  That seems right to me. I have long though that emerging economies should hold around 10% of their GDP as reserves – and it now seems that informal rule of thumb has a bit of empirical support. Of greater interest right now, though, is the fact that their model can be used to determine is a country is holding more reserves than it needs:  “Our framework provides a decomposition of the observed level of reserves between one component that can be justified as insurance against sudden stops and one component that cannot.” What are the results?    Well, Latin America had far too few reserves in the 1980s.    And it has about the right amount now.   Though they note that some unnamed big countries in Latin America are a little on the low side.    Or least they were back in 2004.  Some large countries have increased their reserves significantly since then.“The model might be interpreted to suggest that the current level of reserves is, on average, adequate in Latin America.   However if is important to note that reserve coverage is estimated to be insufficient in some relatively large individual countries.” Emerging Asia, by contrast, now has far more reserves than it needs.  “For the Asian countries following 1997-98, however, the model suggests that the buildup of reserves has been excessive – a finding consistent with previous analyses.”Indeed, their model suggest that Emerging Asia economies held twice as many reserves as they needed in 2004.  Asian countries had reserves equal to 26% of GDP; Jeanne and Ranciere's model suggest that they only needed reserves equal to 12% of GDP.   See p. 30.    And since 2004, Asian reserves have only gone up.  Particularly in one very big and important country.  Jeanne and Ranciere don’t provide the level of reserves their model suggests a country like China should hold.  But given the structure of their model, it seems safe to assume that China has a relatively modest need for reserves.  It doesn’t have much stated public debt, which cuts its need for reserves.  You can argue that China has more public debt than the reported in the official data, given all the bad bank loans, bad local government debt and the AMC bonds that the central government will eventually have to assume.   But China doesn’t have an overvalued exchange rate.   It certainly doesn’t have an internal balance sheet mismatch.  And it isn’t integrated into global capital markets.   If emerging Asia is over-reserved, it is safe to assume that China is very-over reserved.  Even those who are not obsessed with China's reserves, though, should take a look at the Jeanne-Ranciere paper.  It makes a real contribution to the debate on reserve adequacy in the emerging world.   And it is precisely the kind of work the IMF should be doing.p.s. Olivier Jeanne was a colleague during my stay at the IMF.  I don’t know Romain Ranciere personally, so i am not 100% sure that he is part of the Francophone world -- though his surname is suggestive.

That would be me.  I like David Brooks’ pop sociology – for all its inaccuracies -- better than I like his politics.And when he used the term Christmas Ohioan in his Times Select column two weeks, I felt a pang of recognition.Ohioans are leaving the state, only to return for the holidays, because manufacturing is shedding jobs.   Some of that is byproduct of productivity growth.   More goods can be made with fewer people.  Some, I suspect, is the by product of global competition – including the impact of competition spurred by exchanges rates that the central banks of some manufacturing powerhouses have kept lower than they otherwise would be.Kansans are leaving the state because of agricultural productivity growth, not Argentine exchange rate manipulation.   One man (or woman), a modern tractor and a modern combine can grow an awful lot of wheat – a lot more than a man, an old tractor and an old combine, let alone a man, a team of horses and threshing machine.    One Walmart, a fleet of trucks, an interstate, a global supply chain and customers willing to drive an hour for a bargain (that is part of Walmart’s distribution) can sell the goods formerly sold by a lot of small stories – and generally with fewer workers and lower price.  Some of the labor no longer needed to work the land and the shops that sell to those who work the land ends up in university towns in the Midwest.   Some ends up in suburban Kansas City.  Some ends up in DC.  And some ends up in New York City. I grew up in a (thriving) university town, not a (slowing shrinking) small market town built around a grain elevator, the local bank and the country courthouse. But I am still touched by occasional story about small town Kansas that runs in the Times, particularly if the story is done well.   I am aware that change – Schumpeter’s creative destruction – sometimes doesn’t just mean moving into new activities.   Sometimes it also means moving away.Those who have left are not in the greatest position to comment on the politics of those who have not.    But I am heartened by stories that suggest Kansan politics is returning to the center – after a long period when it drifted away.

The increase in China’s q3 reserves was about $30b below my expectations.  China’s current account surplus is usually about $15b per quarter larger than its trade surplus, and net FDI inflows have been around $15b a quarter as well.   That implies $80b in reserve growth, not $50b. What happened?   Richard McGregor – citing Qing Wang – thinks it is possible that China encouraged state banks and state firms to hold on to their dollars, not to sell them to the central bank. McGregor in today’s FT. Qing Wang, of the Bank of America in Hong Kong, said in a research note that the authorities had made “systematic efforts to encourage major financial institutions to keep their foreign exchange assets offshore”. This includes allowing state companies, such as the banks that have listed overseas, to leave some of the billions raised in initial public offerings offshore. That story makes sense to me.    Chinese purchases of US assets have been very, very strong in q3 – a data point that is consistent with offshore accumulation of dollars by Chinese state firms along with continued reserve growth, but not consistent with a big fall in the overall accumulation of foreign assets by China. I don’t doubt that China’s policy of limiting RMB appreciation (the pace of appreciation slowed in October) and keeping Chinese interest rates below US rates has limited hot money inflows.   But I would be surprised if $30b or so in hot money really left China in q3.  China has long used its state banks and state firms to support state goals – like creating jobs.  Now it looks to be using them to limit the PBoC’s fx exposure. I guess that is the quid pro quo for helping state banks and state firms out in other ways, not the least buying dud loans off their books at par.

In late 2004 and early 2005, Nouriel and I estimated that the actions of foreign central banks might be holding US yields down by as much as 200 bp. That estimate found its way into Pam Woodall’s Economist Survey.  And it then caught former Treasury Secretary Rubin’s eye. Robert Rubin is a wise and cautious man.   He didn’t want to endorse the results of work that he hadn’t personally evaluated.   So he qualified his remarks by noting: "I read something the other day (probably from the Economist) that -- if it were not for the inflow of capital from abroad -- our long-term interest rates would be as much as 200 basis points higher.  I don't know who did the work or how accurate that is.  But you may have had a distortion of the bond market by these vast inflows." (emphasis added)Rubin caught us.  The 200 bp call didn’t emerge from careful empirical work.    It represented our best judgment at the time.  Back then there hadn’t been all that much empirical work on the question.    And some of that work had found effects that seemed much too small, given the scale of central bank intervention.  Subsequent empirical work, I think, has been reasonably kind to our initial judgment.  Let’s review the evidence. Remember, the 200 bp estimate was made in the fall of 2004 and in early 2005 – back at the peak of the “conundrum.”    The US economy was recovering, the US fiscal deficit was quite large by any standard, US policy (short-term) rates were rising and, well, US long rates weren’t.  That also was back at the peak of foreign central bank demand for Treasuries.  I think it is reasonable to conclude that an awful lot of that demand came from the Bank of Japan, acting on behalf of the Ministry of Finance.  Other central banks do buy Treasuries, of course, but many do so in ways that don’t register quite as cleanly in the US data (see below). Moreover, our estimate explicitly included both the direct and indirect effects of central bank intervention.The direct effect is obvious.   Central banks have been intervening in the foreign exchange markets of the world at an unprecedented pace over the past few years – and as a result, they have a ton of dollars and euros that they have to invest.  And they generally invest those funds in relatively safe bonds – whether Treasuries, Agencies, of Euro-denominated bonds of comparable quality (one interesting side note: the Italians are the biggest source of supply of euro-denominated government bonds, and, well, they aren’t exactly the best of all euro-denominated sovereign credits – something that may contribute to the dollar’s enduring popularity). The indirect effects are more amorphous and harder to quantify.Expectations of central bank intervention shape the actions of private market participants.   This is most obvious in Japan.   Japan has a history of intervening heavily to keep the yen from strengthening (too much).   If market participants expect Japan will act that way in the future, they will be more comfortable borrowing yen to buy higher-yielding assets abroad.   After all, the big risk of such a trade is a sharp appreciation of the yen.   And if the ministry of finance won’t let that happen, the carry trade becomes more attractive.   Think of it as government action that reduces the risk of a “fat tail” kind of outcome … That argument can be generalized.   The fact that central banks stand ready to buy dollars and dollar-denominated bonds if private investors aren’t willing to buy (enough) of them to finance the US deficit makes private investors more comfortable holding dollars and dollar-denominated bonds.  Ask PIMCO.   All their forecasts are premised on the continuation of the “Bretton Woods” system.More generally, by keeping their exchange rate weak, the central banks of countries like China held down the price of their exports and thus the price of many imported goods, That helped keep inflation down in the big advanced – and increasingly housing and consumer-drive economies.    In retrospect, though, the nature of this effect isn’t as clear as it seemed at the time. Intervention by China’s central bank has helped keep the RMB from rising and thus helped to hold down the price of many traded goods.   That I have no doubt.   And it thus contributed to holding core inflation down.     But China’s overall impact on inflation is a bit less clear – intervention contributed indirectly to China’s investment boom, and thus to rising commodity prices.   Philippe d'Arvisenet of BNP Paribas has a good summary of the debate -- he argues that rising commodity prices have offset about half the effect of rising imports from low wages countries.  And then there are all the issues around how to accout for the rising price of housing … Quantifying these indirect effects is hard.  It isn’t obvious to me that there is any real way to gauge how expectations about central bank behavior have shaped private expectations. I don’t know of anyone who has seriously tried.    At the same time, I think many in the markets accept that central banks are now shaping their own activities (Ken Rogoff has a few colorful quotes). But there have been a series of studies that have tried to quantify the direct effect of central bank purchases on US bonds.     The Banque de France (Gilles Moec and Laure Frey) found the largest effects: they estimated that, at its peak in 2004, central bank demand for Treasuries subtracted 125 bp from Treasury yields.That study, though, has a couple of problems.   One shouldn't be a problem, but it probably is.   French economic analysis is (unjustly in my view) considered an oxymoron in some parts of the US.  Their study hasn't gotten the attention it deserved.The other is a real problem.   The Banque de France worked off the US data on central bank purchases of Treasuries.   That isn’t a problem for 2003 and 2004 – back when the Japanese were intervening like mad and buying treasuries like mad and those purchases showed up as both Japanese and central bank purchases in the US data.   But it is a bit of a problem now.    Lots of other central banks prefer to buy their Treasuries in ways that don’t register as central bank purchases in the US data.    That was likely the case in 2005.  Central bank demand for Treasuries fell sharply (no more Japanese intervention).  But total foreign demand for Treasuries didn’t fall (lots of petrodollars had to be invested somewhere … ).   The Banque de France methodology would record a big fall in central bank demand, when, in all probability, “true” central bank demand didn’t fall as fast as implied in the US data.A recent study by Francis Warnock and Virginia Warnock deals with both problems.   Warnock teaches at Virginia, is affiliated with Trinity College Dublin and has done lots of works for the Fed as well as the IMF.  He can hardly be accused of being (god forbid) French.   And his approach looked at total foreign demand for Treasuries, not just measured central bank demand. The result: Warnock and Warnock estimate that foreign demand for US treasuries held yields down by about 90 bp in the spring of 2005 – the last data point in their study.And an awful lot of that effect seems to be the product of the Asian demand.  See Figure 4b. But if you look at their Figure 3a and 4b, it is clear that foreign demand had a bigger impact on Treasuries in 2004.  At its peak, they seem to estimate an effect of around 130 bp.   OK, that isn’t 200 bp.   But it isn’t 25 bp either.   And 130 bp is only the direct effect.   Warnock and Warnock do not try to do the impossible and estimate the extent Chinese intervention has helped hold down core inflation, the extent that Japanese intervention – and expectations of renewed Japanese intervention should the yen ever move too fair – have facilitated the yen carry trade or the fact that Bill Gross sleeps a lot sounder at night despite holding a lot of dollar-denominated claims with a low nominal yield (currently under 5%) on a country with a huge current deficit … True, a substantial debate remains.   But I still would argue the 200 bp estimate has aged relatively well – though I would tend to put the effect at closer to 150 bp today.It is worth noting that foreign demand for Treasuries of all types dried up in the first half of the year.   That reflects a couple of things.  The Japanese authorities seemed to shift some of the Treasury portfolio into Agencies.   The Chinese are buying more Agencies and corporate bonds (most likely mortgage backed securities that are not guaranteed by an Agency) and fewer Treasuries.   And the oil exporters seem to have lost interest in Treasuries as well.It isn’t clear, though, that the impact of central banks on US markets disappeared.   Agencies are a pretty close substitute for Treasuries.    Not a perfect substitute, but a close substitute.   Still, as central banks snap up a wider range of debt – and, alas, often buy debt in ways that the data doesn’t fully capture – the challenge of accurately estimating their impact on the market will only become more difficult.More importantly, it seems likely that central banks didn’t completely lose their appetite for Treasuries.  It seems the world's central banks were waiting for the Fed to end its tightening cycle before locking in long-term rates.   Foreign demand for Treasuries remerged in August.  I would bet September was similar.  One last set of points for the true geeks.  Warnock and Warnock’s appendix has a very useful run-down of the limits of the US data on foreign inflows.  Data from the custodial accounts of FRBNY (the weekly H4.1 release) provides the most timely data on foreign official holdings.   But Warnock and Warnock note that the FRBNY data is very partial: “FRBNY is just one of many custodians that foreign governments might use.  For reported US capital flows data, the FRBNY is the custodian of choice for many of the world’s central banks and finance ministries …. However, some foreign governments, notably Middle East oil exporters but also others, avoid the FRBNY and this source is best described as partial.” (emphasis in original)Well said.  Obviously, as oil exporters reserve growth increased , the value of the data series from the FRBNY custodial holdings fell.    More recently, Russia seems to be running down its custodial balances in the US – though I am not 100% sure these are held at FRBNY.  China doesn’t entirely avoid FRBNY (best I can tell), but it also doesn’t seem to use it almost exclusively (unlike, say, the Japanese).  The TIC data doesn't hinge on FRBNY custodial data.  But it too has a few problems.“It is well known that the TIC system is not able to correctly differentiate between foreign official holdings and other foreign investors (such as pension funds, stabilization funds, insurance companies and others) when the trade is made through a third party intermediary, we will utilize overall TIC foreign flows into Treasury and Agency bonds in constructing our preferred measure of foreign official accumulation.”They also note that flows into Agency bonds need to be adjusted for amortization payments. I agree.  That is why I am skeptical of studies that use very narrow measure of foreign official holdings (the FRBNY series, even the BEA’s data) as the basis for estimating the impact of central bank flows on the US.Indeed, if the Chinese are buying private mortgage backed securities – that is, mortgage backed securities that lack an Agency credit guarantee, total inflows into Treasuries and Agencies may miss some central bank purchases … 

It seems the Russian central bank has been buying yen when no one else wanted too …Interesting.   At one time, Russia was a source of global financial instability.   Now, well, it is a big part of the global market.   Nothing like almost $270b in the bank.Incidentally, the valuation gains Russia’s central bank reported on its reserves in q2 imply that it was holding a bit more than 45% of its reserves in dollars.   At least at the beginning of q2.    But it could have shifted away from the dollar during the course of q2.   Who really knows.

Those are two of the headlines on Reuters right now.   So much for the notion that hedge funds correct prices that deviate too much from fundamentals.   Slowing US growth, a widening trade deficit, buy dollars.  The dollar did dip after the trade data was released, but not much.  I guess strong import growth could be interpreted as evidence that the housing slump hasn't spilled over into the broader economy.  But it also could be interpreted as evidence that (net) exports won't contribute positively to growth either.The $70b ($69.9b) August trade deficit means the US is squarely on track for a $900b or so current account deficit this year.   The q3 trade deficit looks set to come in at somewhere between $205 and $210b.  Add in a $20b transfers deficit and a $10-15b income deficit and the current account deficit should chalk in somwhere between $235 and $245b.And don't buy the spin that it is all just oil.  True, the price of imported oil was $66.12 this year.  It will be lower soon.   But the real story in the August data seems to be that non-oil import growth is picking up.  Non-oil goods imports were $133 in August, above their recent $128-29b range.   The y/y growth rate in non-oil imports was 9.85% in June, 10.8% in July and 13.4% in August.   Memo to Stephen Jen: There is no way the trade deficit, let alone the current account deficit, can fall with those kinds of non-oil import growth numbers. Export growth continues to be strong, and strong across the board.  Exports to Europe (the EU) are up by 13.2%, only a bit less than exports to the Pacific Rim (up 13.8%).  The country by country data also suggests a pickup in non-oil import growth.   Imports from China grew by about 20% y/y in August, up from 16% in July -- and faster than the 17% increase in the YTD number.   The 20% increase in US imports from China is still well below the 30% plus overall increase in Chinese exports in August, but it is consistent with the acceleration in the pace of export growth that shows up in the Chinese data.  And China's strong September export growth data suggests that the trend continued. More generally, very rapid growth in US imports from China hasn't led to a fall in US imports from the rest of Asia.   Imports from the rest of the Pacific Rim are up about 8% y/y.   That is consistent with the recent trend -- US imports from China are rising fast as a share of US GDP, while US imports from the rest of Asia are growing with US GDP.I wonder if 2006 will shape up a bit like 2005.  In the first half of 2005, non-oil goods imports were stuck around $117b, but they jumped up at the end of the year.   For the first half of 2006, non-oil imports have been stuck around $127-129b.   They clearly jumped up in August.  And the broader data out of Asia suggests that may have continued in September.An increase non-oil imports will be partially offset by a fall in the US oil import bill in q4, if current market prices hold.  But if non-oil imports continue to rise, there may be less improvement in the trade balance than many now expect.Right now, market prices imply a q4 oil import price that will be well below the q3 average.  But current market prices don't imply much long-term relief.   Lest we forget, oil averaged about $52 a barrel in q1 2006. Current oil prices are still higher than the $46.8 average of 2005 -- and are only a bit lower than the $58.9 average price so far this year. They will bring down the q4 deficit relative to q3, but won't help much beyond that.One last point.  I have noted previously that US oil import volumes (Exhibit 18) have been consistently below their 2005 levels in 2006.   For a while, the volume of US oil imports was running about 2% below its 2005 number.   My interpretation was that this was evidence that the US was cutting back on its demand for oil (marginally) in response to high oil prices.  I may have to reconsider though.    Overall oil import volumes are still down about 1% for the year, but August/ July 2006 import volumes were up 2.6% over August/ July 2005 ...  I guess I should dig further though.  That may just reflect Katrina.To sum up.  The August data shows strong export growth.  That isn't a change.  It shows high oil prices.  That isn't a surprise.  It also shows what could well be the beginning of a rise in non-oil imports.   That is a change -- there were hints of a rise last month, but not quite the clear evidence that shows up in the August data.   As Menzie Chinn likes to point out, the "real" trade balance has been stable since the fourth quarter of 2005.  But if non-oil imports continue to grow at a 10% plus pace y/y, the real trade balance won't stay stable for long. 

The dollar has been rather strong relative to the yen for some time now.  And it is currently getting even stronger.  The dollar was weak against the euro at 1.28 – and at say 1.25, it is still pretty weak.  Ask Airbus, which sells planes for dollars and buys parts in euros.  But right now the dollar is also rallying against the euro. And my friends at Danske “Geyser Crisis” Bank think the dollar could reach 1.16 or so.  Ok, 1.16 is just their headline -- but they are looking for 1.20.   Danske doesn’t think that the US is the Iceland of the G-3. If the dollar continues to rally against the other major currencies even as the US economy slumps, well, that will have consequences.   For one, don’t look to exports to help the US get out of a slump.  And don’t look for the US slump to bring about a big improvement in the US balance of payments.  Getting a big improvement in the current account deficit is hard, given that the US imports a lot more than it exports and net interest payments are set to rise sharply. So, setting a big swing in oil prices aside, the scenario where the US trade deficit falls is one where US import growth slows and US export growth stays strong.   Not one where both import and export growth slows.And for that matter, if China's exports continue to grow at a 30% y/y pace -- faster than they were growing earlier this year -- it isn't obvious to me that US import growth is slowing.  At least not yet.  Asian electronics exports seem to be picking up, and presumably not all those exports are going to Europe.Supporting charts and historical data are below the fold.A US slump – even if the slump fell short of an outright recession – would slow US import growth.  But if the market in its wisdom concludes that it should bid up the dollar as the US slows, US export growth also will likely slow.    Particularly if global growth slows a bit. That makes external adjustment a bit harder.    The following graph shows --  I think – that the broad dollar does have an impact on US export growth, with a lag of about two years.  From 1990 to 1996 the dollar -- I used the Fed's broad dollar index -- was rather weak.  The result:  Exports increased as a share of GDP, and broadly speaking kept pace with imports.   From 1995 to 2002, the dollar gained in strength.    And guess what, exports fell as a share of US GDP.   The tech boom of 2000 induced a surge in US tech imports and exports (as well as a surge in oil prices), so export blipped up in 2000.  But the overall trend is down.   The dollar’s 2002-04 slump had the expected impact as well.  Exports are now rising as a share of GDP.     If the dollar rallies, well, export growth will likely slow.If you look at trends in US trade over a longer period, it is striking to me that US exports are not really much higher as a share of US GDP than they were in 1980.    And there seems to be a difference between the widening of the trade deficit in the early 1980s and the widening now.   The fall in the deficit in 80s largely came because  exports fell as a share of US GDP (blame the strong dollar).  Imports were broadly stable.  The collapse of oil prices clearly helped – no doubt oil imports were falling while non-oil imports were rising.   But there also was clearly a lot of capacity in the US export sector ready to respond to dollar depreciation. What is different now – apart from the fact that the deficit is a lot bigger?   The rise in the deficit comes overwhelming from a rise in imports – not a fall in exports.   After the boom of the last three years, exports are now about as large a share of US GDP as they ever have been.   That raises a question in my mind: Is the US currently making the investments needed to bring goods and services exports up to 15% of GDP?   My gut answer is no.   If not, the only real way the trade deficit can close quickly is if imports fall back as a share of US GDP.   And that, unfortauntely, will take more than oil at $55-60.    Bob Rubin has good reason to be worried.   But apparently, on this, Rubin and Greenspan don’t see eye to eye.

It seems, as Shuda Senoy notes, that consumer goods are falling as a share of US imports:   "the proportion of consumption in imports has been falling, i.e., the proportion of industrial inputs has been rising."  (Hat tip Felix Salmon).  Hmm.  Why might that be.  Oh yeah.  Crude oil is an industrial input -- see Exhibit 8.  Refineries turn an imported industrial input (crude oil) into a consumer good (gasoline).  The US generally doesn't imported the refined product directly.The price of many industrial inputs -- especially crude -- has gone up recently.  They are not quite as high as they were over the summer, but they are still up significantly relative to where they were a few years back.  And with US production of crude oil falling both absolutely and relative to US demand, the US has had to import more of it over time.  Senoy's analysis just conveniently forgot to note that fact.Commodity prices are a wee bit higher than they used to be.  Thank China.  Prices of imports of consumer goods haven’t moved much recently.  Thank China, which subsidizes the rest of the world’s consumers by holding down the RMB’s value.   There is a more general problem with the argument that consumer goods, or impotrs from Asia, have fallen as a percent of US imports..  Imports have been rising as a share of US GDP.  So something can fall as a percent of total imports and still be rising as a share of US GDP.I haven't looked at the data on imports of consumer goods carefully, so I don't know for sure what has happened.  But the argument that consumer goods imports are falling as a percentage of total imports seems to be a variant of an argument that I have looked at, namely that Asian imports are falling – or at least not rising – as a share of total imports.   Most US imports from Asia are consumer goods.  And I can assure you that US imports from Asia are not falling relative to GDP. There is a variant of the same argument that floats around – Mickey Levy of the Bank of America made it at the JEC hearing.  It goes as follows:Consumer goods imports are falling as a share of US imports.    Capital goods imports are rising as a share of imports.   Ergo, imports are not the product of a “consumption boom” – they are the product of a boom in capital spending. Alas, the broader data doesn’t support that argument.  Consumption has risen as a share of national income (as household savings has fallen).   And business investment remains below its 2000 levels.    Overall investment hasn’t fallen by as much, but that is because of a surge in residential investment.There is an alternative way of looking at the rising share of capital goods imports in total imports.   The US may not have as big a competitive advantage in capital goods production as it once did. Capital goods imports also come significantly from Europe and Japan – not China.   So their prices have – I suspect – risen even as China has kept down the price of consumer goods imports.   German, Swiss and Swedish engineering isn’t quite as cheap as Chinese made DVD players stuffed with Japanese, Taiwanese and Korean components.Bottom line: don’t trust any argument that looks only at imports from Asia as a share of total imports.  Or consumer goods imports as a share of total imports.   It is an easy way of slanting the data.   With imports rising rapidly as a percent of US GDP, something can fall as a share of total import and still be rising relative to GDP.  It is sort of like any argument that looks at China in per capita terms to argue, see, China really isn’t that big a deal.    China’s per capita current account surplus, you see, isn’t that big.   That’s true.   No one matches the per capital current account surplus of Kuwait, the Emirates and Saudi Arabia.  Their surplus is the counterpart to the rise in US imports of “industrial supplies” like mineral oil.  It also is irrelevant for the debate over global adjustment.One note: I edited this for clarity/ crispness after initially posting it. 

I recently gave a guest lecture on the global balance of payments.  After the lecture, I was asked what would happen to the US economy if China let the RMB float.  I think I was right to say the RMB would rise if the PBoC stopped intervening.  Right now, China is spending somewhere north of $250b to keep the RMB from rising against the dollar.  That tells me something.  And I think I got another point right: for the time being, it is a purely hypothetical question.  China isn’t about to let the RMB float.  The real debate over the pace of RMB appreciation.  China isn’t about to stop intervening. But I wasn’t happy with the rest of my answer.  I got tied up in knots thinking about how a change in the RMB/ $ would influence the bilateral US imbalance.  And never felt like I really gave a clear answer.  At least not as clear an answer as the question deserved. The nice thing about a blog, though, is that I can attempt a do over.And rather than starting with the impact of a rise in the RMB/ $ on the US-China bilateral trade balance, I want to start with the impact of a rise in the RMB on China’s overall current account balance. Let’s assume that sustaining China’s current de facto peg requires that China add about $275b a year to its reserves.   That reflects a $225b current account surplus, and $50b in net capital inflows.   If Chinese export growth continues at its torrid August pace, $275b might be too low.   And the relatively subdued net capital inflows reflects the fact that China is actively encouraging outflows – by encouraging outward FDI, by loosening controls on outflows, and by holding domestic interest rates well below US rates.  Floating means that equilibrium in the foreign exchange market would have to be achieved without this $275b in intervention.   And that means one of two things: The RMB could appreciate to the point where rising imports overwhelm any increase in China’s dollar export revenues.  China’s current account surplus would fall.      Or the RMB appreciates to the point where Chinese (and foreign investors) do not want to hold RMB – at least not at current interest rates – and private capital outflows match China’s current account surplus. Both imply some changes in the composition of financial inflows into the US.  In the first case, a surge in Chinese imports leads China’s savings surplus to disappear.    That means a fall in demand for US financial assets of all kinds – a disproportionate share of China’s reserves are currently in dollars.   And particularly a fall in demand for Treasury and Agency bonds.    In the second case, a $225b Chinese current account surplus is offset by $225b of private capital outflows from China.    That too would likely imply a net reduction in Chinese demand for Treasuries, Agencies and mortgage backed securities.   The People’s Bank of China has a relatively diverse portfolio – for a central bank.   But its reserve portfolio is still way overweight US fixed income assets with limited credit risk.   Private Chinese investors would presumably demand a different mix of US and foreign assets – probably fewer dollars and more equities.   So even in this case, there would be a change in the composition of capital inflows. All in all, I think it is clear that there would be some fall in demand for US long-term debt – and thus somewhat higher US interest rates.   But the overall impact depends on what ends up happening.  Does China’s current account surplus fall.  Or does the RMB rise to the point where Chinese private capital outflows replace Chinese reserves.  That leads to an analysis of the impact of a stronger RMB on China’s trade.   The impact of a stronger RMB on Chinese imports is obvious.  They would go up.   In the near-term and over time.  That would benefit the US.  But the US isn’t likely to be the biggest beneficiary of a surge in Chinese import demand.  The US doesn’t produce lots of goods to begin with.  Europe and Japan have a bigger share of the industrial world’s manufacturing capacity than the US …  and many US-produced goods are geared for the high-income US market, not for low-income markets. The impact on China’s exports is a bit more ambiguous, as least in the short-run.  In the long-term, I do think there would be a slowdown in the pace of China’s export growth – and the overall volume of Chinese exports would be lower than it would be in a world where China holds the RMB down.  But in the near-term, the world might just end up paying more for Chinese computer assembly, not buying less Chinese computer assembly.  It isn’t obvious that there are real alternatives to China, at least in the short-run.  Of course, if the world pays more, it will buy a bit less.   But the price effect might trump the volume effect: the terms of the Chinese-assembled goods for financial assets/ natural resources/ capital goods trade would shift in China’s favor. In effect, there are two potential channels for adjustment.  In one, Chinese firms maintain their current profit margins (in RMB) by raising their dollar prices to offset changes in the RMB/ $.   And the world pays more rather than buying a lot less.   China’s exports rise substantially.  As does the amount of money the world spends on Chinese assembly.   From the US point of view, the price of Chinese imports rises – and this trumps any rise in US exports.  The US-Chinese bilateral deficit rises in the short-run. In the other, Chinese firms defend their market share and reduce their RMB prices – cutting into their profit margins – to offset the RMB’s rise.    US import prices still rise, but not by as much.   And in dollar terms, China’s exports don’t rise by as much.  This is a scenario where China’s current account surplus likely falls.   Why.  Imports rise in dollar and RMB terms as China imports more.  But exports don’t rise by much in dollar terms … and in the extreme even fall in value in RMB terms.    Chinese firms are squeezed, so they save less.  And that should cut into China’s saving surplus.  Of course, Chinese firms aren’t the only ones who would be squeezed.  So would all the MNCs who operate in China.  Their profit margins would fall.  And they would have far less incentive to shift future production to China. To sum up, there would be a:  A shift in the composition of Chinese demand for US financial assets and perhaps a fall in Chinese demand for US assets.   That depends on whether or not China’s external accounts end up balancing because China’s current account surplus ends up falling, or whether they balance on the back of large private capital outflows. A rise in US import prices.  A fall in the profit margins of US firms producing in China (or subcontracting from firms who produce in China). A rise in US exports to China.   And a rise in US exports to other countries that export more to China.  Obviously the impact of different sectors of the US economy will differ.    Some will clearly gain (US exporters, US workers in sectors that compete with Chinese imports).  Some will clearly lose (US consumers who buy lots of Chinese goods, US workers in sectors that produce the kinds of debt that the PBoC likes to buy) The mix between these different effects, though, is hard to assess.   China external accounts are so far from balance and only clear with massive PBoC intervention.  So the adjustments required to bring them into balance could be quite violent.  I believe RMB adjustment is necessary.  But that doesn’t mean that I think the immediate impact on the US will be overwhelmingly positive.   The US right now specializes in the production of the kinds of financial assets the PBoC wants to buy (think housing debt), not in the production of the kinds of goods China might want to buy.   Or in the kinds of goods and services that those countries who are better positioned to sell to China might want to buy … That means the US, not just China, has an interest in gradual adjustment.    Martin Wolf is discussing a similar set of issues in a much more high profile way.    In the comments on his last column, Willem Buiter argued, more or less, that China should be running large – say 10% of GDP current account surpluses.  He didn’t persuade Martin Wolf.   Or me.   More on that later.