Council on Foreign Relations

Dani Rodrik didn’t take long to stir up the blogosphere (see Steve Waldman, among others).  

Rodrik makes an interesting point:   Trade doesn’t cut inflation.   Sure, it lowers prices for imports.  But it also raises prices for exports …

Let’s step back and think for a second how that applies to the United States’ trade with China.     The US imports a lot of stuff from China (almost $300b worth last year).  All the talk of the China price (or a trip to Walmart) suggests that Chinese supply has kept prices for a lot of goods that China makes pretty low.   

The US doesn’t export that much stuff to China.   To be sure, Boeing sells quite a few planes to Chine airlines – very strong foreign demand for Boeings has offset weak US demand for Boeings recently, and presumably pushed the price of Boeings up a bit.    But in aggregate, US goods exports to China are 20% of US goods imports from China.   China tends not to pay full price on many of the “services”  — think audiovisual services like films and television programs – that it imports from the US, so adding services wouldn’t change the balance enormously.

So maybe the overall impact of trade with China has been to lower prices?   Not so fast – 

While the US doesn’t sell that many goods to China, others do.  Capital goods producers (think Germany).  And above all commodity producers.   The “China price” for copper, iron ore and soybeans is high – not low.   One effect of China’s growing trade with the world has been to push up the price of commodities – and thus to push up the price of a certain set of  US imports …

It also has pushed up the price of food since corn and sugarcane are – at least with a bit of help – substitutes for gasoline at the “China” price for gasoline.   

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I’ll be in England next week, visiting the Global Economic Governance Programme at University College, Oxford and participating on a panel at the Euromoney fx forum.  

I plan to post on Monday and Tuesday. But not later in the week.  I’ll be running around London on Wednesday and Thursday — and seeing just how far (or not) a buck takes you in Europe's — if not the world's — biggest financial center these days.   

The panel is on central bank reserve diversification.  If anyone has any advice on what I should emphasize (or tips about the behavior of the world’s big central banks), I am all ears!  

The reasons why the US slowdown — led by a fall in investment — didn't lead to an improvement in the trade balance in the first quarter aren't that hard to find.  

Consumption growth was actually very strong — nearly as strong as in 2004 (see p. 5) .  That was a year when the trade deficit really widened.   Strong consumption growth pulled in imports — especially, I suspect, Asian imports.  Canada exports lots of wood and autos, and neither housing or the US automobile sector is doing well right now.   And European exports to the US face the a large currency headwind.

But what of exports?  Shouldn't a booming global economy — and weakish dollar — help boost US exports?   In theory, yes.   But that didn't happen in the first quarter.  The BEA estimates exports fell a bit in q1 (v. q4).   And looking at the US export data, I can see why.   The y/y rate of export growth has slowed — and the q/q growth rate (using a rolling three month sum that takes December-February as the last quarter) has been decelerating sharply for the past couple of months.  

What happened?   To be honest, I don't know.  Part of it is that export growth was very strong in q4, and net exports contributed very strongly to growth in q4 (see p. 6).  That set a high base.

Part of it is that the dollar isn't really all that weak.   It is very weak — it hit a record low v the euro today — against all European currencies.   And it is weak against the commodity-exporting, high carry, high current account deficit countries in the South Pacific.   But it isn't weak against the yen, against the RMB or against many other emerging currencies.    The story right now is generalized euro strength, not generalized dollar weakness.

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One. Yes, Virginia, exchange rates do matter … 

Japan’s trade surplus is rising.  Its current account surplus should be rising even more, as its interest income should be increasing too.   The MoF is getting a bit more on its US portfolio.  And Japanese housewives investing in Australian and New Zealand bonds get a bit of carry as well …

What of Korea, an Asian economy that has allowed its currency to appreciate significantly against the dollar, yen and yuan?  It now has a current account deficit.

There is a bigger point.   On a global level, it seems pretty clear that Asia’s current account surplus is still rising.    China’s surplus is growing fast.  Japan’s is growing a bit more slowly.    That suggests that the fall in the oil exporters’ surplus may be offset by a rise in Asia’s surplus, not a fall in the US deficit.    Something to watch.

Two.  Someone is betting on the revaluation of the Kuwaiti dinar

Kuwait’s reserves exploded in March, presumably because a surge in capital inflows led to a surge in intervention.    Some in the Gulf aren’t so keen on these “speculative” inflows, but in this case, speculation is doing nothing more than putting pressure on the Gulf to correct an obvious misalignment.   The Gulf is booming, the US is slumping – and the Gulf’s link to the dollar leads to imported inflation.  Rather than importing macroeconomic stability from a dollar peg, the Gulf is importing a lot of things it doesn’t need. 

Three.  China’s hidden foreign exchange reserves remain large …

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The Economist (New York byline): 

“However, it’s not clear how much impact this [A more freely floating currency] would really have on exports. For many of the products it exports, China is merely an assembler of parts made elsewhere, which is why its trade surplus with the rest of the world is less impressive than its bilateral one with America. Should the yuan rise, it will make those inputs cheaper for Chinese firms, so export prices will rise less than the yuan-bashers might hope.”

Murtaza Syed of the IMF (box 1.2 of the Asian regional outlook). 

“China has often been described as the assembly line of the world, combining expensive high-tech imported inputs with cheap domestic labor to assemble final goods that are exported predominantly to developed markets in Europe and North America …    According to this view, as long as China retains its competitive advantage in cheap labor, movements in external demand and the exchange rate would have limited impact on China’s trade balance.

However, there situation may already be evolving, as a result of increased production capacity and capability with China …  According to this alternative view, the domestic content of Chinese exports is rising fast … as a result the trade balance is likely to be more responsive to movements in the exchange rate and fluctuations in external demand. 

The dramatic shift in China’s trade and production structure observed in recent years tends to support the later view.  Over the last two years, China’s current account surplus has risen by nearly 5.5% of GDP, as import growth has begun to lag export growth by a significant margin.”

I tend to agree with Syed and the IMF on this one.   Take a look at the chart on p. 24 of the IMF’s regional outlook showing the evolution of China’s trade balance with various regions of the world economy.  Since 2004, China surplus with the US and Europe has continued to rise while China’s deficit with the rest of Asia has fallen.   And if you look at the chart showing Chinese domestic production of semiconductors (which had to be put on a separate scale …) it is pretty clear that some previously imported electronics components are now made in China.

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Plenty of signs suggest that a fair amount of money is leaving Japan to look for higher yields elsewhere.    More and more of those outflows seem to be coming from leveraged investors who borrow yen to buy other currencies – look at the excellent analysis by Hali Edison and Chris Walker in the IMF’s Asian regional outlook (box 1.4).

But it doesn’t seem like much of it going to the US.  At least not directly. 

There are plenty of places that offer higher yields than Japan that don’t even have current account deficits – the eurozone for one (its deficit is very small).   Brazil for another.   Russia too.

There are places that offer higher yields than the US but run smaller deficits.   The UK comes to mind.   India too.  Australia perhaps fits here – its overall deficit is about the same size as the US deficit (though its composition is different; Australia has a smaller trade deficit but a large deficit in investment income) 

And then there are places with bigger deficits than the US.    New Zealand.   Iceland.   Turkey.   All offer higher yields than the US.

So how then has the US managed to finance its deficit?   After all, current ten year Treasury yields don’t suggest “foreign flight”? 

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Like many with strong opinions, I sometimes criticize (politely, I hope) press coverage of topics that I follow closely. 

For example, I have long thought that coverage of China’s consumption boom should be qualified by noting that exports and investment continue to grow faster than consumption.    As a result, consumption is still trending down as a share of China’s GDP.  That helps to explain how savings growth has been able to outpaces investment growth.   China’s current account surplus is rising, not falling.  

But more often than naught, I am impressed by how well the financial press covers difficult topics.    For example, Andrew Batson’s reporting of China’s very strong first quarter GDP in Friday’s Wall Street Journal hit all the right notes.    Batson's reporting combined reactions to China's GDP data from some of the best Anglophone China watchers around – Jon Anderson, Nick Lardy, Louis Kuijs – with the reaction of key Chinese policy makers.

Li Xiaochao – the spokesperson for China’s National Bureau of Statistics – seemed to indicate that China intends to continue to take a series of small steps to try to slow its growth without changing too much.

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The IMF – as the FT, Stephen Roach and William Pesek have all noted — has decided to stop worrying about what might go wrong in the global economy and start celebrating all that is going right.   

Slower US growth doesn’t even imply slower global growth.  

Not with China growing even more rapidly than in the past, helping commodity exporting emerging economies in the process.   

Not with Europe doing well.   Two years ago the conventional wisdom was either that Germany hadn’t reformed enough or that it had adopted the wrong kind of reforms, so it couldn’t grow.  Now the conventional wisdom seems to be that it did enough to lay the basis for sustained growth …  

Large and growing imbalances haven’t caused any problems to date.  The markets aren’t worried.   David Hale isn't worried.  The G-7 isn’t worried.  Academics generally aren’t worried.    

Why then should the IMF worry?  

While the world's imbalances are large, they aren't expected to get bigger.   Look at the following chart, which is based on the forecast in the IMF's World Economic Outlook.

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Latin America may not think much of W (or the US — more here), but they seem to have no problem financing W’s Treasury. 

I previously have mentioned that Brazil’s reserves increased by close to $25b in the first quarter.  Nothing much has changed.  Brazil added another $2b to its reserves last week. 

Brazil isn’t alone.  Argentina added $4.8b to its reserves in the first quarter.    There are rumors (denied) that Colombia is considering soft capital controls to limit the peso’s appreciation.   The central bank certainly has been active: it apparently bought about $3.9b in the first quarter to try to hold the peso down (more here).   Even Peru is joining the game.  It has bought over $500 million so far in April to try to limit the sol’s appreciation.

Compared to China’s reserve growth, these are fairly small numbers.  But they are big for Latin America.   They add up.

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They are also getting close to a record low v. the euro. 

Yet oil is, well, still rather strong.   Against the dollar.  But also against the pound and euro.   The euro and pound have gained significantly on the dollar over the past few years, but oil has gained even more. 

A little while back I noted that the impact of China's depreciation against the euro (really Asia's depreciation against the euro, as most of Asia still tracks the dollar and the yen is rather weak) on trade and investment flows was an under-reported story (That may be changing: see Keith Bradsher's new story in the New York Times).   

I also suspect the impact of inappropriate currency pegs – like the de facto currency union between the world's biggest oil importer and the world's biggest oil exporter – is an under-reported story. 

Inflation is now rising throughout the Gulf.  Quite significantly in some places.   A weaker dollar (riyal, dinar, dirham) is the last thing the Gulf countries need now that they are really starting to spend their oil windfall.   

The Kuwaitis seem to get this – even if they are (perhaps) constrained by the GCC’s commitment to peg to the dollar in advance of their planned (but increasingly unlikely) currency union.  The Saudis, well, not so much. 

John Sfakianakis of the Saudi Arabian British Bank just issued a long report arguing against a revaluation (hat tip, Mikka Pineda).  A key argument: imported inflation from the dollar’s 12.5% slide v. the euro can not possibly explain a 40% increase in retail prices.   (40%!)    And since imported inflation is overstated, so too is the case for a revaluation.   John Gamble of SAMBA — another Saudi Bank — went through the full range of possible inflation fighting tools in a recent report.  He though rather cursorily dismissed a revaluation on the grounds that its wide ranging economic impact made it an inappropriate tool. 

I wasn’t convinced.    The dollar’s slide may not explain the rise Saudi inflation – which likely reflects a fall in “fiscal” sterilization as the Saudis have started to spend more of the windfall from the rise in oil prices.   As more of the oil windfall converted into riyal and spent locally, money growth has picked up (Saudi m3 growth was close to 20% in 2006).  That is the core reason for the pick-up in inflation.

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