Everyone is Working Hard to Increase Global Trade Imbalances

I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis.

I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.

Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:

South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.

A few days ago the Financial Times had another interesting, related piece.

Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.

…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.

Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation.

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:

A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.

“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”

I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here. Rather than comment I will quote extensively from the article:

Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.

…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.

Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks.

…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange.

Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there.

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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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