U.S. Dollar Depreciation is Probably a Necessary Process

The US trade deficit unexpectedly narrowed in August, according to the Commerce Department in a report released on Thursday. Exports were up slightly and imports down, mostly because of a reduction in oil imports, I think, but the trade deficit was still a hefty 3.6% of GDP.

So does this mean that the rebalancing is grinding forward? Thursday’s New York Times is appropriately cautious:

“Officials cannot just sit there and do nothing, and expect the rebalancing to continue,” said C. Fred Bergsten, director of the Peterson Institute for International Economics. Indeed, American consumers are already showing hints of their old fondness for shopping rather than saving. The household saving rate shot up from less than 1 percent before the crisis to more than 5 percent this spring, but it has since slipped back to less than 4 percent. In the early 1990s, American families were saving about 7 percent of their income — and even that was less than in much of Asia and Europe.

Simon Johnson, a professor of economics at the Massachusetts Institute of Technology, said it was normal for a country’s trade balance to improve during an economic downturn. “The adjustment we’re seeing right now could be the harbinger of a real adjustment in saving and spending, but we don’t know yet,” Mr. Johnson said. “People in emerging markets want to run big surpluses, because they want to build up reserves.”

There clearly still is a long way to go if the US is really going to raise its savings rate to some sustainable level, and I am afraid that part of the necessary policies that will lead there will cause a lot of disruption and conflict. Basically in order to raise the savings rate the US needs to enact policies that are similar in spirit to the policies that China has enacted especially during the past decade – and of course which China now needs to reverse. These involve putting into place conditions that spur output growth and constrain consumption growth. The difference between the two, of course, is the savings rate, and if output can grow faster than consumption, by definition the US savings rate will rise.

Given the huge differences in the two economies, and the even bigger differences in the accepted roles of the two governments in their economies, the US will have to accomplish this in a very different way than China does. The US of course cannot work to constrain wage growth and force households to subsidize producers out of interest income, as China seems to have done, but there are other policies that will have the same effect.

For example, consumption taxes, or at least much higher taxes on oil, will have the effect of constraining consumption growth by reducing the real value of household incomes, and if these taxes are somehow matched by lower taxes on interest income the net effect will be to use consumption taxes to subsidize the cost of capital for producers. These are the sorts of policies that can force a continued rebalancing in the US economy.

There is another obvious way of doing so, and this involves the currency. Last week Jean-Claude Trichet, president of the European Central Bank warned against the further strength of the euro against the dollar. At roughly the same time Asian central banks, worried that the failure of the renminbi to appreciate against the dollar would cause their economies to lose export competitiveness, intervened heavily in the markets to slow the appreciation of their currencies against the dollar.

Meanwhile China’s press is fulminating against claims that the renminbi must be revalued. An editorial in Xinhua last week had this to say:

The Group of Seven rich nations have again pushed developing China to appreciate its currency, the RMB yuan, so as to promote a so-called “more balanced growth”. On Saturday, G7 central bankers’ meeting held in Turkey’s Istanbul failed to produce any significant boost to the world economy. Instead, they turned fire on China’s currency, blaming it for the financial crisis.

In so doing, the rich nations have obviously intended to shirk their due responsibilities in the wide-spreading global financial turmoil. As it is known to all that the current crisis has been a result of developed countries’ lax financial regulation, excessive consumption and their lasting monopoly on the international financial system.

They are supposed to review loopholes in their micro-economic policies and financial regulation. However, some of them have tried to link the “under-evaluated” RMB exchange rate to the “global economic imbalance”, which they said had been the major factor behind the crisis.

According to their logic, China should appreciate the yuan considerably to cut exports and increase imports, so that Western nations’ trade deficit can be narrowed and “a trade balance” be achieved. They have turned a blind eye to China’s efforts to make the yuan more flexible.

All of this highlights the fact that a depreciation in the value of the US dollar is probably a necessary part of the adjustment process, but it is going to be extremely difficult. Overvalued exchange rates are part of the mechanism by which the US runs a trade deficit. An overvalued dollar increases the real value of US household income by lowering the costs of imports while effectively taxing manufacturers in the tradable goods sector.

This automatically forces consumption to grow faster than production and helps push the country into a trade deficit. Meanwhile countries with undervalued currencies have the opposite experience. As the cost of imports is forced artificially high and the producers of tradable goods are subsidized by the undervalued exchange rate, it is no surprise that growth in production exceeds growth consumption, leaving these countries with persistent trade surpluses.

So if we expect the US to reduce its consumption levels relative to its production (i.e. raise its savings rate and bring down the trade deficit, it is reasonable to expect the dollar to decline.  An editorial in Financial Times makes just that point:

It would actually be rather helpful if the dollar were to weaken further. Politicians everywhere see strong currencies as national virility symbols, but the effect of a cheaper dollar would be to help American exporters while making imports to the US dearer.

This is what America – and the world – needs. In the medium term, as Mr Summers put it earlier this year, “the rebuilt American economy must be more export-oriented and less consumption-oriented”. In short, the US must start living within its means, and the rest of the world must stop relying on its profligacy.

But against what can the dollar depreciate? Europe and Japan can make plausible arguments that their currencies are not undervalued relative to the dollar and so they should not be forced to bear the brunt of the dollar depreciation. Asian countries, and especially China, have relied on undervalued currencies as an important part of the package of policies aimed at spurring domestic growth and high domestic savings rates, and because the decline in US imports has already proved very painful, they are insisting that they should be forced to bear any more of the cost of dollar depreciation. The FT editorial continues:

This is the prospect that has worried monetary authorities in Asia. The central banks of South Korea, Taiwan, the Philippines and Thailand have intervened in markets in the past week to bolster the dollar’s strength against their currencies. They are trying to slow the pace of any such rebalancing.

That is understandable: this type of reordering of the world economy would be enormously disruptive for these export-led countries, since their economic strategy is to sate the appetites of the consumption-led countries.

Everyone seems to agree that as part of the necessary global rebalancing the US will have to reduce its net imports, and this will be achieved in part by a depreciation in the value of the dollar, but everyone also seems to agree just as fervently that any reduction of the US trade deficit should not come at their expense, but rather at the expense of the rest of the world. Europe says it is Asian that must appreciate, Asians implicitly insist that it is Europe that must appreciate. It doesn’t take a PhD to see the mathematical difficulty.

Like in the 1930s, every country wants to devalue its currency relative to the currencies of its trading partners in order to boost domestic employment and take a larger share of foreign demand. But as we learned in the 1930s, it is by definition impossible for everyone to improve export competitiveness by devaluing.

So how will the disagreements be resolved? Almost certainly by an increase in trade conflicts. What many of the global participants have probably forgotten is that in a world of contracting demand, it is countries who control net demand who are in the strongest position to determine the outcome of a fight over trade. If the dollar is not allowed to depreciate in an orderly way against the currencies of all of its trading partners, trade tensions have no way to go but up.

Evidence? How about this, in an article in Thursday’s Financial Times:

The US Department of Commerce announced on Wednesday it would launch an investigation into the import of seamless steel pipes from China, a move which could lead to new duties imposed and strain already sour trade relations between Washington and Beijing.

The US investigations, which could lead to a 98.7 per cent duty on Chinese steel pipes imports, came shortly after a European Union decision to impose anti-dumping tariffs on the same category of products.

Or this, in another Financial Times article published the same day:

Global trade tensions ratcheted up on Thursday as the US opened an investigation into Chinese steel imports and clashed with the European Union over chickens.

…The US has long complained that the EU has blocked chicken meat washed with chlorine and other chemicals from sale in Europe, despite both US and European scientific agencies concluding that such treatments were safe for consumers. But a panel of the chief veterinary officers of the EU member states rejected the treatments late last year. The outgoing Bush administration started legal proceedings against the EU in January, and negotiations since have failed to resolve the issue.

A European Commission spokesman said that litigation was not the appropriate way to deal with such complex issues. ”However, since the US has chosen this path, we will defend our food safety legislation,” the spokesman said.

The fact is that these trade disputes are not going to go away, and because each side has legitimate complaints, or at least what seems like legitimate complaints to domestic audiences, without serious global coordination (don’t hold your breath) the only very likely outcome is even more trade disputes. And these are disputes which will be won by the country or countries that control the one resource everyone in the world wants: net demand. This means that if surplus countries don’t allow for a rapid and orderly adjustment of the imbalances, which will require a rise in the value of their currencies among other things, the same thing will be achieved by trade conflict.

What are the prospects? I guess regular readers of my blog will be disappointed if I don’t show myself to be a pessimist, but in fact anyway I think the prospects for an orderly resolution are weak. I am not knowledgeable enough about other countries, but it seems to me that China certainly is not prepared for the cost of the adjustment and will continue trying to postpone it. On Thursday Liu Mingkang, chairman of the China Banking Regulatory Commission, told a conference in Hong Kong that “It’s far too early to talk about an exit strategy”, which I interpret to mean that the investment-driven stimulus package is going to continue. He said that Beijing did not need to rescue the banking system, and the measures it has taken to boost investment and to support the infrastructure sector were to help the economy. Of course he also said that he believes the banking sector is sound, so maybe he is just kidding.

For those of you who are able and willing to follow the complex world of chemicals, there is a related and very interesting article by John Richardson on ICIS news, a chemical industry publication (you can also find it here). He says:

Low density polyethylene imports into China were up by 85% in the first eight months of this year compared with the same period in 2008, according to International Trader Publications Inc, a provider of trade data and analysis on chemicals and polymers.

Benzene imports increased by 185%, polyvinyl chloride by 138% and methanol by 431%. These latter two statistics are the result of weaker economics of coal-based production as well as re-stocking and stronger demand.

“Year-to-date totals were up for every commodity polymer, engineering polymer and major organic we follow except expandable and non-expandable polystyrene, polyacetals, polycarbonate and ethylene dichloride,” said Jean Sudol, president of ITP.

This implies high inventories in not just PE – the only polymer in which we gained clear evidence through a survey among 85 distributors and end-users carried out by a major Asian producer. It’s easy to overcomplicate things but to put it simply, it seems impossible that this extraordinary surge in imports has gone into a sufficient increase in finished-goods sales to prevent some major dislocations.

All you have to do to reach this conclusion is look at real consumption growth (not the misleading retail sales figures) versus the decline in exports to work out that a lot of overstocking is likely to have occurred. This would be at the chemical and polymer levels and in warehouses full of unsold washing machines and refrigerators etc.

I am no expert on the chemical industry, and so perhaps I am misreading his piece, but this doesn’t sound like an industry that is readying itself for a world of contracting US demand.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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