With Global Imbalances Returning What Are America and China to Do?
November 17, 2009
by
With the APEC summit held last week in Singapore making many headlines, issues of trade deficits and currency valuations are in the news quite often. Various governments and non-governmental organizations have warned strongly against what the IMF says are “global imbalances.” In its World Economic Outlook released last month, the IMF forecasted a return to growth of these imbalances and the latest global trade data seems to confirm the trend has begun. As I pointed out last month, trade had been trending flat of late, bad for global GDP but good for correcting trade imbalances.
As China’s role in global economics continues to increase, the term “G-2” has been coined to refer to the U.S.-China relationship. It is a play on the terms for the economic summits known as the G-8 (Group of Eight) and G-20. Increasingly, the world is taking its cue from this duo but that leading appears to be little more than status quo.
The “imbalances” refer to trade and capital flows between two sets of countries: one set that are net exporters and one set that are net importers. Since the Asian crisis in 1997 the net exporters led by China, Japan, Germany, and oil-rich nations have increased trade surpluses by an annual rate of 13%. At the same time, the net importers composed of the U.S., the U.K. and a host of smaller European nations have allowed their trade deficits to grow at a similar rate. A look at the largest U.S. deficits paints the basic picture:
U.S.-China trade remains the primary source of imbalances. The trade deficit that the U.S. runs with most its trading partners has declined in the past year. Much of that decline can be traced to the reduction of industrial production and oil prices that, while high, remain far below last year’s levels. As mentioned in last week’s article, industrial production is on the rise and the resumption of trade growth explains some of that trend. With a trade surplus versus the U.S. that is four times as large as the next single country, China remains the largest factor in U.S. trade.
These imbalances are decades in the making but began to accelerate twelve years ago. The 1997 crisis set Asia on a course to become a region of net export to America and much of Europe. Increasingly, these countries would export more than they import and accumulate the resulting foreign currency in reserve. This reserve was to be a rainy day fund to reduce dependence on foreign borrowing and demonstrate financial austerity to the global capital markets. Reserves could be employed to thwart speculators attacking a currency as happened to Thailand at the beginning of the crisis.
Today these foreign currency reserves (about two-thirds of which are U.S. dollar based) are measured in the trillions.
Leading the importers, the United States has for the last decade sent dollars and dollar denominated debt to these countries at increasingly rapid rates. Leading the exporters, China accumulated these dollars and dollar-based debts but now worries as the capital markets drive down the value of the dollar in foreign exchange markets.
China’s motivation for reserve accumulation was less about financial stability (it was little scathed by the Asian Financial Crisis) and more about currency management. An undervalued Yuan allowed growth to accelerate through its trade surplus. As a result China accumulated the dollars it received from trade and foreign investment. Thus its reserves grew in line with its trade surpluses.
It is in the control of either side to correct these imbalances. China, for its part, could float its currency (the Yuan), stop accumulating dollars, and begin selling the dollar assets it has. The government is reluctant out of fear of China losing its competitiveness in manufacturing, risking the jobs of a few hundred million factor workers. Not to mention it would hurt the value of the dollar and its own vast reserve of dollar-based assets.
Releasing controls over the currency would result in a dramatic rise in the value of the Yuan but its affect on Chinese manufacturing is less clear. Take Japan as an example. After years of external pressure Japan freed the yen from currency controls after the signing of the Plaza Accord in 1985. In the period that followed the Plaza Accord, the yen appreciated by three fold from more than 250 yen/dollar in early 1985 to less than 82 yen/dollar a decade later. This was the beginning of the end of the Japanese economic miracle but not before the suddenly strong yen caused assets to bubble and burst. Japan today remains a strong exporting nation but with an economy that few envy.
The United States also has the means to almost unilaterally correct this problem. Of course, the solution is too painful for policy makers to seriously consider. U.S. authorities could change fiscal and monetary policy to increase interest rates, let inflated assets find their own bottom, rein in government spending, and restructure tax policy to favor investment over consumption. Such a prescription would be akin to a cancer treatment; necessary for the longer term outlook but excruciatingly painful in the near term. Unemployment would soar far beyond today’s 10.2% and millions left without benefits. However, the U.S. dollar would strengthen and the trade deficit would be reduced dramatically.
The APEC summit only confirmed that the U.S. is not interested in changing its near term fiscal and monetary strategy while China is not interested in adjusting its currency policy. Additionally, last week’s trade figures indicate a return to days of growing U.S. trade deficits. Well intentioned programs like the “cash-for-clunkers” program in the U.S. has had the unfortunate affect of growing reviving U.S. deficit growth. Polite rhetoric will have to do for now.
In the last year it began to look like the unsustainable imbalance would correct on its own under painful market forces. However, the coordinated government effort “to save the global financial system” also has preserved the problems that came with that system.
Goods imported into America are growing again. The trade deficit for physical goods (merchandise) is at the center of the United States’ trade deficit. This deficit widened to $47.6 billion in September. While it is still far from last July’s high of $77 billion, it is now increasing quickly from the low of $37.2B hit back in back in February and again in May. About half of the increase in deficit since is a direct result of higher oil prices. The other half is from increased trade activity.
Before investors flock to shares in Chinese companies, it is worth looking at what is fueling the deficit growth.
Autos imports fueling U.S. deficit growth could be short lived. Cars and automotive parts were imported into the U.S. in September at a level almost double that of the spring months of March, April, and May. The above graph looks at the contributions to the growth in trade deficit from May to September. Price increases are factored out to look at true underlying trade activity. We find that automotive imports made up three-quarters of the growth. September was the last month of the cash-for-clunkers program in the U.S. This stimulus-induced program did benefit trade with Japan, Germany, and Canada (to a lesser extent). This trend may have already reversed with the end of the program, though.
Chinese imports to the U.S. are predominantly consumer goods, the category which remains the largest area of deficit for the U.S. but it was one that has actually shrunk in recent months.
U.S. imports from China are well behind 2008 levels. Chinese stimulus programs have been successful in keeping production going in China but they can not get American consumers to buy more. Imports from China all year have run behind 2008 and 2007 levels. These imports tend to peak in the month of October ahead of the American Christmas season and so will likely turn down from November.
Imports from China to America are only running 15% behind 2008 levels. I say “only” because Germany and Japan are running 33% and 37% behind last years levels respectively. After disastrous performance of German and Japanese export sectors late last year, any positive growth might be sufficient. China, on the other hand, is trying to demonstrate 8% or greater growth no matter what the conditions. Imagine a company trying to describe 8% growth in the midst of a recession and sales to your largest customer are off 15%. You can understand that letting the currency appreciate is the last thing Chinese authorities want; better to just keep accumulating those dollars.
So what is the G-2 to do? Apparently, not much. China and the U.S. are the two economic powerhouses that need to act if global imbalances are to be addressed. Last week was just a reminder that there is any serious desire on either side of the Pacific to do much. With U.S. unemployment so high and consumption of Chinese goods so low, it looks like everyone’s goal is to just get back to 2007, problems and all. What’s a few more trillion in currency reserves anyway?
Disclosure: No Positions
