Pettis on the European Crisis

From China Financial Markets Newsletter

Michael Pettis 

Seven steps to crisis

Step 1. The German savings rate rises. 

Thanks to the labor reforms, German wage growth dropped sharply, and with it the household income share of Germany’s GDP. As the household income share declined, and because the household savings rate remained flat, the household consumption share also declined. 

Because most consumption is household consumption, and Berlin did nothing to counteract the decline in household consumption, for example by increasing social spending, the total consumption share of GDP in Germany also declined during this period 

All goods and services produced by an economy (i.e. GDP) are by definition either consumed or saved. As Germans consumed a smaller share of all the goods and services they produced, by definition they saved a larger share. Germany’s saving rate, in other words, rose.

Note that Germany’s savings rate rose not because German households decided to become thriftier but rather because the growth in wages and overall income, and therefore in consumption, was suppressed by the Hartz reforms. 

Step 2. Weak consumption growth in Germany lowers private sector investment.  

Businesses expand production capacity usually because they expect demand for their product to grow. As consumption growth lagged, however, German businesses responded by reducing their investment growth rate to below the GDP growth rate.
When investment is equal to savings, everything that is produced is purchased either for consumption or investment purposes. The demand generated by investment absorbs all the goods and services that an economy has produced but has not consumed. In Germany however savings rose faster than planned investment. 

Step 3. As German savings began to grow faster than GDP, and planned German investment more slowly, there were four different ways in which the German economy could adjust: it could run a current account surplus, unemployment could rise, public sector investment could rise, or something could set off a rise in consumption faster than the rise in GDP. 

It could run a current account surplus. Germany could sell to foreigners the excess of goods and services it produced at home but could not sell in Germany. In that case Germany would also export the excess of savings over investment, and so run a capital account deficit. The value of the current account surplus would be identical to the value of the capital account deficit, with excess German saving financing the purchase by foreigners of excess German production. 

Unemployment could rise. German businesses could respond to growing inventories by cutting back production and firing workers. This would cause the total production of goods and services to drop. Total consumption would also drop as unemployed workers reduce their consumption, but because unemployed workers must still consume, the total production of goods and services would drop faster than total consumption, or, put differently, the savings share of GDP would drop. Rising unemployment, in other words, reduces the savings rate, not because consumption rises faster than GDP but rather because consumption declines more slowly than GDP.  

Public sector investment could rise. The German government could borrow the excess savings and invest it in ways that increase German productivity. Higher government investment would counterbalance higher savings and the decline in private sector investment so that German savings would no longer exceed German investment. 

A consumption boom could be set off. German investors could use excess German savings to buy assets like stocks or real estate. As asset prices rise, and the owners of these assets see their wealth rise, two things can happen. First, the “wealth effect” can cause Germans to increase their consumption faster than their income increases. Second, rising asset prices can cause them to increase their investment, especially in real estate. The first effect causes the savings share of GDP to drop and the second causes the investment share to rise, either of which retains the balance between savings and investment. 

Step 4. In fact Germany ran current account surpluses and capital account deficits, mainly with other European countries.  

For policy reasons Berlin and local German governments did not absorb the excess savings by borrowing and investing them locally. 

During this time European financial authorities were encouraging a convergence in interest rates among very different European countries with very different interest-rate histories, creating a sharp division between some countries, such as Germany, in which inflation had been low and interest rates historically low, and other countries in which inflation had been high and interest rates historically high, too. In the former the real cost of this available German capital was high, while in the latter, which we will call “Spain” in the rest of this essay, the real cost of this available German capital was low. 

Every economy consists of business and household entities with a wide range of risk appetites and optimism about the future, ranging from recklessness to prudence. When real interest rates are very low or negative in a growing economy, because of the diversity among businesses and households in their appetite for risk, inevitably some of them will borrow more than they otherwise would have in order to consume or invest more than might have been prudent. If we assume that Spain has exactly the same distribution of risk-seeking borrowers as Germany, and exactly the same distribution of reckless agents as Germany, and we offer Spanish and German borrowers equal access to capital, but at high real rates to the Germans and at low or negative real rates to the Spanish, most of the excess German savings will flow to Spanish borrowers and very little will flow to German borrowers. The difference between the two countries, in other words, is not in the distribution of reckless behavior but in the divergence in real interest costs. 

Some commentators have argued, bizarrely enough, that the causality is backwards, and that in fact all of the countries that we represent by Spain embarked on ill-advised consumption binges that occurred only coincidentally at the same time as Germany implemented the Hartz reforms. It was the subsequent collapse in Spanish savings rates, these commentators say, that caused them to wrest capital away from German investors, and the surge in their consumption that caused them to scoop up German tradable goods. It was Spain “pulling” capital and tradable goods out of Germany, in other words, and not Germany who was “pushing” capital and tradable goods into Spain. In the former case, however, Spanish borrowers could only have pulled capital out of Germany by forcing up interest rates, and by pulling tradable goods out of Germany, Spain would have also forced up the growth in German wages. The fact that European interest rates declined sharply during this period, and German wage growth decelerated sharply, would be extraordinarily counter-intuitive at best.  

Step 5.  “Spain” must accommodate the German current account surplus and the corresponding capital account deficit.  

Spain had been importing moderate amounts of foreign capital before all of this happened, but after the Hartz reforms, the distortions in Germany were so great that the amount of excess German savings pouring into Spain in a matter of 3-5 years increased by 20-30 percentage points of Spain’s GDP. Spain’s corresponding current account deficit also soared to among the highest levels in its history. Just as Germany’s soaring current account surpluses and capital account deficits reflected a rising excess of German savings over German investment, the soaring current account deficits and capital account surpluses in Spain had to accommodate a rising excess of Spanish investment over Spanish savings. These are automatic consequences of net capital inflows.  

There are four ways this could happen: Spain’s productive investments could rise, its non-productive investments could rise, Spanish unemployment could rise, or the Spanish consumption share of GDP could rise. 

Spain’s productive investments could rise. More available capital at lower interest rates increases the amount of productive investments in Spain, which causes Spanish demand for investment-related goods and services to rise, including for tradable and non-tradable goods and services. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, much of it must be supplied from abroad. 

Its non-productive investments could rise. More available capital at lower interest rates also increases the amount of non-productive investments in Spain to the extent that investors are unable to distinguish between the two. There are three reasons why non-productive might rise.   

First, the rush of capital into Spain can cause GDP growth to rise, which can cause investors, including local governments, to overestimate future demand for infrastructure, and this is all the more likely when widespread corruption creates strong incentives to over-estimate future demand. 

Second, when cheap capital pours into a country it can cause soaring asset prices, and as real estate prices soar, they create speculative demand for real estate, which creates even more scope for non-productive investment. Third, as German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity is increasingly unproductive. For all these reasons, as non-productive investment in Spain rises, as in the case of productive investment, it causes Spanish demand for investment-related goods and services to rise, including for tradable and nontradable goods and services.

Spanish unemployment could rise. As German tradable goods increasingly displace Spanish tradable goods, Spanish investment in capacity becomes increasingly unproductive and Spanish manufacturers have to fire workers. Rising unemployment causes the savings rate to decline (as explained above). Before the 2008-09 crisis, however, fired workers were quickly hired by the rapidly-growing non-tradable goods sector, so the effect of the German tradable goods sector on Spanish unemployment was minimal until the crisis, with its effect being a shift of workers out of the tradable goods sector into the services and non-tradable sectors. 

The Spanish consumption share of GDP could rise. More available capital at lower interest rates increases the amount of speculative investments in existing Spanish assets, such as stocks, bonds, and real estate. As their prices rise, Spanish households, especially those with greater risk appetites, believe they have become permanently wealthier, and they respond by expanding the consumption share of their income. They fund this increased consumption either by reducing their savings or by borrowing against their assets. This causes Spanish demand for consumption related goods and services to rise. As unemployed workers are put to work, part of this demand is met by rising supply, but unless unemployment in Spain is extremely high, eventually much of it must be supplied from abroad.  

In three of these cases (excluding the third, rising unemployment) as Spanish demand for investment-related and consumption-related goods and services rose faster than Spanish supply of either, it had to import them from abroad, but because it can only import tradable goods (and some tradable services), an automatic shift had to occur in Spanish employment. Workers were transferred from the tradable sector to the nontradable sector, so that demand for tradable goods rose even faster, and this was resolved effectively by importing these goods from Germany.  This is a simplification, and technically incorrect, but we will continue to use it over the rest of this essay. The goods that Spain imports as a consequence of the German capital “push” don’t have to be imported only from Germany. They can be imported from other countries, which simultaneously increase their imports from Germany, so that the rise in Spain’s current account deficit will be exactly matched by a rise in Germany’s current account surplus even if the two do not occur bilaterally.  

Step 6. As speculation and cheap capital causes markets to rise, the Spanish debt burden will automatically rise until speculative price increases and a rising debt burden reach their limits.  

The different ways described above in which Spain could have responded to the increase in capital imports each has a different impact on the Spanish debt burden.

Capital that flows into productive investments does not result in a rising debt burden because the capacity to service debt rises as quickly, or more quickly, than the debt servicing cost. 

Capital that flows into non-productive investments causes the debt burden to rise because there is no consequent increase in the capacity to service debt, even as there is an increase in the debt-servicing cost. 

Capital that finances the increase in consumption also causes the debt burden to rise because there is no consequent increase in the capacity to service debt while there is an increase in the debt-servicing cost. 

When debt-servicing costs rise faster than debt-servicing capacity, the growth in debt is unsustainable and it becomes increasingly necessary to roll debt over as principle and interest come due.  

Rising asset prices and rising debt are self-reinforcing, but neither is infinite, and both will eventually be forced to stop rising. There are many triggers for the reversal, which we do not need to get into here, but once it happens, market prices fall, and it becomes more difficult to roll over the debt. This occurred in 2009, and the consequence was that German capital stopped flowing into Spain. As a result Spanish governments, businesses and households could not service existing debt to Germany and they could no longer fund the domestic consumption and investment that had previously been funded by German savings.

Step 7. When something is unsustainable, eventually it will stop. 

As Spanish and other peripheral European debt rose to levels at which creditors were increasingly worried about funding further debt increases, and as the underlying economies were damaged as resources were misallocated as a result of asset price distortions, all it took was a trigger to set off a system breakdown. The US sub-prime crisis served as that trigger. Once creditors became sufficiently concerned about the adverse impact of US events on underlying liquidity, they began to raise interest rates, reduce maturities and otherwise transform liabilities in ways that were highly selfreinforcing, and in a very short period of time deficit countries found themselves unable to refinance their external borrowings. Without balancing inflows on the capital account, their deficits had to collapse.  

By definition a collapse in the current account deficit can occur either in the form of a drop in investment or a surge in savings. Investment dropped when creditors became unwilling to fund new investment and as stock and real estate prices collapsed, and the savings rate rose as Spanish households cut back on consumption. The net result was a sharp drop in demand and a corresponding surge in unemployment. 

After the crisis there were a limited number of ways Germany and Spain could adjust. Once the rest of Europe was no longer able to absorb the German surplus, and because Germany took no steps to rebalance domestic demand but instead maintained the existing distortions in which German workers and German households retained a small share of GDP, the export of German savings abroad meant that the full European surplus, perhaps the largest ever recorded as a share of global GDP, had to be absorbed abroad. 

In light of the June 23 Brexit vote, it might be worth noting that the British current account deficit, which had ranged between 1% and 3% for most of the previous decade, jumped 3.6% in 2008 and dropped back to its normal range over the next two years. Since then, as the European surplus has surged, the British deficit has climbed steadily to over 5% by 2015 and substantially higher in the first quarter of 2016. This requires one or both of two British consequences, rising unemployment or rising inequality.

Lessons 

It's not just the outflows we need to worry about but the initial inflows.

Capital flows require more management (i.e. restrictions and regulations) if we want to avoid the negative consequences of unproductive capital inflows. This in turn requires a realisation that the 'market' cares about profit not productivity. Profit can be made in remarkably unproductive ways.

It's not cultural propensities that should be the major explanatory variable for economic outcomes. Rather it is macroeconomic flows shaped by policy (ie. institutions) that are most important. Culture and path dependency will shape what are considered to be appropriate policies. In sum, institutions matter more than culture, although culture may shape what institutions are chosen and developed in the first place.

For Australia, a negative spiral might begin with an external reassessment of investment opportunities or a decline in employment. Given the highly indebted status of Australian households this would reduce consumption and lead to a reassessment of the housing market.

A housing price collapse in Australia would lead to a reassessment of debt, a collapse in consumption and rising unemployment, which would lead to further house price falls and so on.

Australia has avoided falling into this negative spiral through a combination of good luck and some good policy. However the rise in debt and the failure of authorities to regulate credit will soon be seen as remarkably poor policy.

The Fallacy of Composition: Return of Global Imbalances and the Possibilities of Trade War

Excess saving is a major problem for the global economy. Just like those painful colleagues who think that arriving early is always virtuous, many commentators and policy-makers see export surpluses as a sign of moral superiority.

Such a view of the world is wrong not only in an ethical sense, but also in a rational one. For every export surplus there must be a deficit. The virtue of the mercantilist must be matched by the supposed iniquity of the consumer. Unless we start trading with another planet, there is no other outcome.

This is a fallacy of composition - the belief that what is true for the part is true for the whole. Not every country can run a trade surplus and absent the willingness of some countries - particularly the Anglosphere countries - to run deficits the whole model would fall apart. 

The surplus countries need to adjust, just as much as the deficit countries if we to restore some sort of balance to the world economy. 

According to Brad Setser  

East Asia’s current account surplus—its excess of savings over investment—has recently amounted to about as large a share of world gross domestic product (GDP) as it did prior to the global financial crisis. In 2015, the region’s four major economies—China, Japan, South Korea, and Taiwan—along with the city states of Hong Kong and Singapore had a combined current account surplus of $700 billion. Their combined surplus significantly exceeded Europe’s surplus. No region of the world currently contributes more to the global glut in savings. Outward flows of capital from East Asia present a challenge to the world economy, and this problem may grow in the next few years. 

East Asia’s surplus is all the more remarkable because it has reemerged despite two factors that act to reduce it. China’s investment remains at historically high levels and Japan’s budget deficit is around 5 percent of GDP. Both high investment and large fiscal deficits absorb significant amounts of savings at home. These two surplus-reducing factors are overwhelmed, however, by East Asia’s extremely high rate of saving. At close to 40 percent of GDP, it appears to be at a record level relative to the size of the region’s economy. Without a reduction in the savings rate, there is a risk that East Asia’s already large surplus will increase. To control its bad-debt problem, China may reduce credit creation and investment. To control its government-debt problem, Japan may opt for fiscal consolidation. In either case, policies that reduce domestic risks could give rise to new global risks.

While before the crisis the net European surplus was low (i.e. European trade and financial interactions with the rest of the world), it has been growing since that time as austerity reduces consumption and as the export surplus countries have continued to repress consumption in the belief that export surpluses are virtuous. If only Greece could be more like Germany they argue. But as we pointed out at the beginning this isn't possible for every country. Germany doesn't have to become like Greece, but it does need to reduce its export surplus and export some of its demand to southern Europe.

The United States trade deficit is likely to become an important marker of the success or failure of Trump's Presidency and while the deficit on petroleum products has been reduced since the crisis due to the US oil boom, its deficit in other goods has grown rapidly.

As Setser points out, despite the high investment of East Asian economies, savings are still higher leading to current account surpluses. It is important to remember that the current account = savings - investment. A surplus means an excess of saving over investment and a deficit means not enough saving to fund investment. The latter is the case for Australia.

All of this leads to global imbalances as captured by the graph below,  On top are the surpluses, which include the East Asian and European surplus economies. Note that with the decline of oil prices, the oil exporting countries are now running deficits. The largest share of the deficit side of the equation is taken up by the Anglosphere economies - the United States, the United Kingdom, Canada and Australia.

East Asia is the major contributor to global surpluses, but the European surplus economies have also expanded theirs. This is exactly the opposite of what needs to happen in Europe. To help solve the crisis in Southern Europe will require the surplus countries to increase their consumption and lower their savings. They need to increase demand in their own economies rather than importing demand from southern Europe. This is all the more important given that monetary union has negated adjustment via the exchange rate. 

The major global problem, however, are the East Asian surpluses. This is partly because they are larger and partly because they affect the United States to a much greater extent. Setser contends: 

There is an urgent case for a strategy to reduce East Asia’s savings rate to a level that the region can more easily absorb internally. The adjustment should be centered on China, where exceptionally high levels of savings no longer serve the same purpose as during the country’s catch-up phase of economic development. In the past, high savings allowed China to finance high levels of domestic investment without drawing on potentially risky, reversible, cross-border capital flows. However, with the gains from high levels of investment now reduced, a national savings rate that still approaches 50 percent of output is simply too high to be absorbed effectively at home or abroad. China’s high savings rate increasingly implies either bubbles in credit and investment domestically or large capital surpluses that have to be exported and that add to global risks. 

Although China is the prime source of the savings glut, South Korea, Taiwan, and Japan also contribute. Savings rates of 35 percent of GDP in South Korea and Taiwan generate more capital than can be absorbed domestically. South Korea’s current account surplus is just under 8 percent of GDP, about the same share of its GDP as the surplus of Germany, the leading non-Asian contributor to the savings glut. Taiwan’s surplus is at an even higher 14 percent of GDP, although the effect is mitigated by Taiwan’s smaller economy. Japan’s surplus of 3 percent of GDP is comparable to that of the eurozone as a whole. 

Over the past few years, the nature of the policy challenge posed by East Asia’s external surplus has changed. The region’s surpluses are no longer maintained primarily through intervention in the foreign exchange market, with the result that moving toward floating currencies is no longer a sufficient policy response to Asia’s trade surplus. The traditional U.S. economic agenda in the region— aimed at liberalizing trade, investment, and exchange rates—also misses the threat that East Asia’s savings glut poses to global prosperity. U.S. economic diplomacy now needs to advance policies that lower national savings in East Asia directly. These include the use of fiscal policy to support an increase in household consumption and reforms in high-saving East Asian economies to strengthen the social safety net and thereby lower private savings.

Given that the 'savings glut' or global imbalances were a major factor in the global financial crisis we should all be worried by these developments. A Trump administration is unlikely to accept the United States' traditional role in soaking up these surpluses. This means that unless East Asian surplus countries reduce their savings (and surpluses) we can expect a Trump administration to focus on what the United States can do. The easiest 'solution' will be to impose new restrictive measures on East Asian trade. 

This means that either East Asia adjusts its policies or the United States will force adjustment through trade measures. This could lead to a trade war as nationalist sentiments awaken in the trade arena and the surplus countries maintain their belief in their moral superiority for running trade surpluses. 

The Global Imbalances: Janus-faced Adjustment

Global imbalances may have come down slightly since the lead up to the global crisis. but they still exist as the chart and table below make clear. China's surplus has come down but Germany's remains, which means continuing problems for southern Europe.

Resolution of the imbalances would help global growth, but it would require surplus countries to adjust as well.  Germany has benefitted from the Euro and repressed consumption, which led to a current account surplus and the export of capital to Southern Europe. This capital led to increased private debt in Spain and was used to inflate property prices.  But remember the problem has two sides - the capital exports and unproductive borrowing, leading to unbalanced current accounts. This means that the solution has two sides - adjustment by both Southern Europe and Germany.

China's recent import collapse means that it currently runs a $US60 billion surplus. The question is will the deficit countries continue to accept the huge surpluses of Germany and China or take measures to restrict imports.

There's a lot at stake in Europe right now and the Germans continue to moralise that Southern Europeans need to embrace further austerity. Germany needs to run a deficit not a surplus. Britain could also help out by abandoning austerity.

Europe, China, the United States: What Balance and Whose Payments?

It might be a little bit dorky, but one of my favourite times of the month is the arrival of Michael Pettis's newsletter China Financial Markets. This rather blandly titled missive always provides rational, well argued and interesting comment on the Chinese economy.

Pettis constantly rails against those who don't understand the basic accounting concepts of the balance of payments.

In October last year in relation to the possibility that China could help with Europe's debt problems, he argued that:

Europe does not need capital from foreigners. It is capital rich. In fact it is even a net exporter of capital. The reason certain European governments cannot borrow is not because Europe is capital poor. It is because these countries are perceived to be insolvent, and in altogether too many cases they almost certainly are. 

Bailing out an insolvent government cannot help it. It will give it time to work out its problems, many argue, but the historical precedents suggest that the quicker an insolvent country acknowledges its insolvency and demands debt forgiveness, the better off it is in the longer term. 

... an increase in foreign money inflows actually will make Europe’s problems worse. Europe needs more demand, not more foreign money. More foreign demand is the opposite of more foreign money.

Remember that a net increase in foreign capital means that foreigners are importing demand from Europe. But Europe needs them to export demand to Europe. More foreign capital inflows is exactly the wrong thing – and in fact what Europe really needs is to increase its exports of capital. Paul Krugman, by the way, makes almost exactly the same point when he says: “It is very difficult in real time to convince people that capital inflows pose a threat, no matter how obvious the numbers seem." 

But difficult or not, it is important that policymakers grasp this point and it is important that investors understand the consequence when policymakers fail to grasp it. The trade and currency wars that we are experiencing are nothing more than wars about exporting capital. Exporting capital is exactly the same as importing demand. Every country that wants to run a trade surplus is also by definition a country that wants to export capital. 

And of course every country that accepts net foreign capital inflows must also accept a trade deficit (or, more correctly, a current account deficit). This isn’t a theory. It is an accounting identity.

This sort of reasoning is counter-intuitive to many people. Some of my more knowledgeable students look incredulously when I argue that the United States would actually benefit from a decline in Chinese purchases of US Treasury securities because it is popular wisdom that China holds all the power now that the US is so indebted to Chinese borrowers.

For what its worth, I've always thought that the fact that China lends to the United States at low rates of interest (i.e. bonds) and then uses some of that money to invest to earn higher rates of interest in China was a good deal for the United States and an indicator of Chinese weakness rather than strength. The only problem with this view is that the increased liquidity created by Chinese purchases of US dollar assets was an important factor in the global and US financial crisis. But as Pettis makes clear, Chinese investment in the United States does provide an advantage for China in that it exports capital to and therefore imports demand from the United States. To be blunt, the balance of power in this situation is far from clear.

Pettis has repeatedly pointed out that many people fail to understand this balance of payments logic in regards to the US-China relationship.From his October 31st 2011 newsletter he writes:

Non-economists may think China, with its huge reserves and 9% GDP growth can weather a trade war more effectively than the US. For example in an otherwise interesting article in the South China Morning Post, Lanxin Xiang, a professor of international history and politics in Geneva, says the following:

China owns too many US government bonds and yet the central bankers have always discouraged the government from entertaining any thought of using them as diplomatic leverage in dealing with Washington. But throughout modern world history, using monetary instruments to achieve diplomatic aims is the norm rather than exception. One notable case was the Suez Canal crisis, when Washington threatened to stop market support for sterling to force the British withdrawal from the Anglo-French colonial expedition against Egypt's nationalist president Gamal Nasser. 

I believe Xiang has used the Suez Canal crisis argument before, and it is a very clumsy analogy. The UK desperately needed to import capital from the US in those days to support sterling, whereas today the US is eager to get China to stop exporting capital (there is, remember, no difference between intervening to weaken a currency and exporting capital, and Washington clearly wants China to reduce its intervention). It isn’t likely that a threat by the US to stop exporting capital in the former case is as credible as a threat by China to stop exporting capital in the latter case, but of course this is the kind of mistake that many who don’t understand central banking or the balance of payments mechanism make over and over again.

In fact most economists (economic historians and trade economists, anyway) know that trade wars usually switch demand from surplus countries to deficit countries. Instead of hurting the deficit countries, this actually causes faster growth in the latter, albeit at the expense of slower growth in the former. Trade and currency war, in other words, is bad for the world but not necessarily bad for the deficit countries.  

The thing to note here is that Chinese capital outflows involve the export of demand from the United States and therefore an increase in unemployment in the United States. An orderly fix of the global imbalances (see here for a 2010 discussion) will be required if the world is to avoid an eventual trade war. This means adjustments on both sides of the question, but if China continues to pursue an investment and export-led growth model its current account surpluses must be matched somewhere with current account deficits. The United States has been this major deficit country.

In Europe, Germany's surpluses have been matched by Spain's deficits. Australia also is a major deficit country, although our current account deficit has declined as domestic saving has increased and non-mining investment has moderated.

Pettis makes the point that China's lending to the United States is not a discretionary decision, instead it is a fundamental consequence of its growth model. From his January 8th 2012 newsletter he writes:

Chinese “lending” to the US government is not a discretionary decision that they can choose or not choose to do – it is the automatic consequence of a growth model that requires a trade surplus to absorb domestic overcapacity – the idea that the US government needs foreign funding is based on a very fundamental misunderstanding of the balance of payments.　 The US government does not need foreign buyers for its bonds. On the contrary, it is in Washington’s best interest that foreign central banks sharply reduce their purchases of USG bonds.

He also highlights the need to make distinctions between 'deficits':

foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows. 

The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall. The difference between domestic US investment and domestic US savings, of course, is equal to the net amount of foreign savings imported into the US, and is also equal to the US current account deficit. In this case soaring US investment causes the US to have a current account deficit and leads foreigners to fund this excess investment.

This has some relevance to Australia because we have historically had an excess of investment over saving meaning that we generally run a current account deficit. This is not necessarily a bad thing if the investment is productive. That's a big 'if' and much of the foreign capital inflow into Australia involved household borrowing to buy (and, to a lesser extent, to build) houses, thus bidding up the prices of houses. This game has seemingly finished for the moment at least, partly because the household sector has such high levels of debt at around 150 per cent of disposable income (down from 160 per cent a few years ago).

Note that Pettis makes the point that the direction of causality between saving and investment and between capital exports and imports are not always clear cut. 

But the direction of causality can also run the opposite way. Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.

There are several ways this can happen. One way is for the surge in foreign capital inflows to cause a sharp rise in what otherwise would have been unnecessary or unfunded investment – the real estate bubbles in Spain and the US might be obvious examples of this. Another way is for foreign savings to displace domestic savings, perhaps by funding a credit-fueled consumption boom.

But whether for good reasons or bad reasons there is no escaping the fact that net capital imports into the US, whether pulled by domestic needs or pushed by foreign needs, must be accompanied by a rising US current account deficit – this is just arithmetic. ...

Remember that saying that the US needs more foreigners to buy US government bonds in order to keep interest rates low is exactly the same as saying the US needs a bigger current account deficit in order to keep interest rates low. This cannot be true.

In a recent newsletter (20 March 2012) Pettis makes some astute observations about China and the way that many commentators assume that the Chinese leadership can fulfil their intentions. He argues that this is because they focus on intentions rather than constraints.

This failure to focus on constraints rather than intentions is why I think most analysts have gotten China wrong in the past five years. By misunderstanding how China’s growth model works, and how the functioning of the model forces certain kinds of behavior and prevents others, they have been much less skeptical about Beijing’s ability to execute its intentions than they should have been. I think we should be much less impressed by what the leaders say they will do, and much more concerned about how the constraints they face will limit what they actually can do.

This applies not just to China, but for any country and particularly Europe right now:

This is an issue not just for China, by the way, but for any country. For example, knowing the constraints imposed by the functioning of the balance of payments I am wholly unimpressed by what many senior German and European leaders say they expect to happen in Europe. The fact is that if we hope to see net repayments by peripheral Europe to Germany, we will also have to see a reversal in their respective current account positions, and so far this seems unlikely. Without the latter, however, the former is impossible, no matter how determined Madrid, Rome, Berlin and Paris might be to reduce debt in an orderly way.

So what are the economic options available to the Chinese leadership given both internal and external constraints?

Pettis argues that two initial assumptions are necessary.

The first is that the fundamental imbalance in China is the very low GDP share of consumption. This low GDP share of consumption, I have always argued, reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.

The consequence of this is that investment levels must be kept very high. The question is how much investment can the Chinese government continue to make beyond the historically highest levels for any country ever!

According to Pettis this has "resulted in massive over investment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP."

Pettis's second assumption is that some sort of rebalancing in China is inevitable because its imbalances "cannot get much greater".

The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.

At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.

Pettis quickly points out that he is not suggesting a sudden China collapse, rather he is suggesting that re-balancing must occur eventually either in an orderly or disorderly fashion. It is debt that will eventually force China to re-balance.

Now it is at this point that some students ask me (the good ones I mean) why can't China use the huge amount of reserves it has to pay off its internal debts?

Once again the explanation requires some knowledge of the balance of payments and reserve banking - not every politics student's favourite topics! Instead of making an already complicated post even more complicated, I've provided an explanation here.

The real question about rebalancing is not that it will happen but when. Betting against China or assuming that its growth model is doomed once again reminds me of Keynes's reputed observation about the ability of markets to remain irrational for longer than individuals can remain solvent. Lots of scholars and investors have assumed and bet that China was destined to fail, but it ain't happened yet. Pettis canvasses the more positive arguments:

China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable.

This also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years. The current account surplus, remember, is just the excess of savings over investment. 

The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income (or wealth) share of GDP.

China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption. As I see it, the various ways in which this transfer can take place can all be accounted for by one or more of the five following options:

1.Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.

2.Beijing can quickly reverse the transfers in the same way. 

3.Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth. 

4.Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt. 

5.Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.

Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector. 

Different rebalancing scenarios have very different implications for growth and distribution. For Pettis, the real costs of rebalancing must fall on the state sector.

Remember that for the past twenty years, and especially in the past ten years, the state and business share of a rapidly growing economic pie was also growing, which meant extraordinary growth in the value of assets controlled by the state sector. The household share of the growing economic pie of course contracted, but the rapid growth in the pie ensured that households nonetheless saw their income grow quite rapidly even as their share of total income declined.

When we reverse this process, as we must if there is to be rebalancing, any slowdown in GDP growth will be minimally felt by the household sector (if the rebalancing is managed in an orderly way), but even a scenario of very high GDP growth must result in much slower growth in the value of state sector income and assets. Of course if GDP growth actually slows sharply, which I expect it will, the growth in the value of state sector assets will collapse and perhaps even turn negative. 

In my opinion this change in the growth rate of the state sector will be at the heart of the political economy choices, and difficulties, that Beijing will be forced to address in the nest few years. It is likely to be much easier to keep political leaders happy when the value of the state sector is growing comfortably in the double-digit range than it is when it is growing in low single digits, or even contracting.

The issue then, according to Minxin Pei, is whether the CCP will be 'happy' to let this happen. Pettis discusses economic constraints, whilst Pei talks about political constraints. Pettis goes through the positives and negatives of all the options outlined above:

As I see it these are ultimately the only options – or at least the major set of options – Beijing can choose to follow over the next few years if it wants to avoid a debt crisis. Of course Beijing doesn’t have to choose only one of the above options. What is more likely in fact is that policymakers end up choosing a combination. 

For example we can posit the following. Beijing can choose an intermediate path between the first and second options, and raise interest rates sharply over the next two or three years while also raising the value of the RMB by 10-15% in an overnight maxi-revaluation. 

In order to protect workers from the resulting surge in unemployment, Beijing can instruct state-owned companies and local governments temporarily to hire a huge number of workers for make-work programs (the fifth option) and initially pay for this by increasing borrowing (the fourth option). At the same time it can begin a massive program of privatization, which should include transferring ownership of land to peasants, and selling off assets and using the proceeds to shore up the social safety net and to pay down debt in the banking system. 

This would certainly work economically to rebalance China in a way that guarantees fairly high growth rates over the rest of the decade, but is it politically possible? Here I would defer to Minxin Pei, who might argue that the scale of privatization required is not possible politically. In that case China would end up being forced into rebalancing via the fourth option, with a long-term surge in government debt. 

And this is my point. If you believe my assumptions are correct, then you should agree that China has no choice but to follow one or more of these paths. If privatization is not an option, then a collapse in the economy caused by a rapid adjustment in interest rates and the currency (the second option) might be. If that is ruled out, then perhaps the outcome will be a surge in government debt (the fourth option again), and so on. 

This what I mean by the economic constraints that limit the choices Beijing can make. It doesn’t matter what anyone thinks or wants Beijing to do, if the plan violates the economic constraints, it cannot be done. To be really complete we should outline the political constraints, the environmental constraints, the demographic constraints, the external trade constraints, and so on, although of course this is way beyond my ability, but each of these exercises allows us to escape from the confusion of stated intentions and to focus on the possible.

Interesting times ahead. 

China's Foreign Reserves: What they Mean and How they Can be Used

China's Foreign Reserves are huge. Indeed they are among the largest foreign reserves in the history of the world.

Historically two other countries held huge foreign exchange reserves - the United States in the 1920s and Japan in the 1980s. Neither of those experiences ended well. 

Many commentators see these huge reserves as a marker of growing Chinese power and consequently, of American weakness given that a good deal of those reserves are invested in US dollar assets. I've also seen it written that China should use these reserves to spend within China instead of buying foreign currencies. The problem with this view is that they can't be used domestically. The best explanation on this topic comes once again from Michael Pettis.

In a post entitled "What the PBoC Cannot Do with its Reserves", Pettis starts by explaining how the Peoples Bank of China (PBoC - China's Reserve bank) goes about keeping the renminbi (RMB) (the yuan if you prefer - see here for explanation) at a lower level.

as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency. 

Now the reason the PBoC must buy dollars under the regime is because the rest of China is a net buyer of dollars. Remember China runs a current account surplus, which must be matched by a net capital outflow. 

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market. Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest. 

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar. In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value.

The next issue is how the PBoC funds these purchases of dollars.

It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars. 

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits). 

Here is where things get interesting. China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

...

So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment. 

...

Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).

Pettis then goes on to explain why a revaluation of the Renminbi against the dollar does not cause the simple scenario of huge losses for China and huge gains for the United States that most commentators allude to when they discuss the so-called economic balance of terror between the United States and China. There are still winners and losers, but the equations are more complex than most assume.

Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves. After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms. 

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency. One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt

An appreciation of the RMB cannot reduce the cost of the US government's debt obligations because:

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt. 

But this doesn't mean there aren't winners and losers including within China. Working them out requires an analysis of the "various balance sheets".

In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

For China, the equation is the same. Those who are short US dollars will gain. 

There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

This is where it gets even more complicated.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one. It does not “realize” the loss, however, until it revalues the RMB to its “correct” value. 

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place. When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB. This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB. 

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that. The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

But there are important impacts within China. Who wins and who loses depends "on the structure of individual balance sheets." 

Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose. They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose. 

Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life. The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team. Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country. Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption. This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.

But the fact that the PBoC loses big time does actually matter and although Pettis doesn't mention it, it would actually lead to the same sort of structural changes in the Australian economy that many people in Australia are worried about right now - namely a decline in manufacturing and (traded) services competitiveness. Pettis's point probably is that the rise in household wealth would help to balance the economy away from the investment and export dominated growth model.

But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?

Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts. 

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

Simple right? If you're confused, you're not alone. It is easy to see why so many writers assume simple effects and consequences of actions because the real world complexity of a change in the value of the RMB is much harder to explain. Much easier just to say China loses from a revaluation of the yuan against the dollar!

Still I wouldn't want to betting on the certainty of anything in this field. As Keynes once said: "Markets can remain irrational a lot longer than you and I can remain solvent."

Current Account Imbalances

Now that's a title that may not excite the interests of many readers, but the current account and the wider balance of payments is a vital measure to interrogate a country's economic relationships with the rest of the  world. 

One factor used to explain the global financial crisis (at least as a partial explanation) are the substantial global imbalances between surplus and deficit countries. 

There were several major contentions about the global imbalances between deficit and surplus countries before the financial crisis hit. While the initial focus of most analyses of the global financial crisis was on the absence of suitable regulation, it is necessary to consider both micro (regulatory) and macro (global capital flows) factors behind the crisis. The absence of effective regulation was ultimately responsible, but the huge and unsustainable global imbalances between deficit and surplus countries, and particularly the imbalances between the United States and China played a fundamental role. China bought US dollars to maintain the low value of the renminbi against the US dollar to sustain the competitiveness of its export industries. 

The US CAD, which is predominantly a trade deficit rather than an income deficit – was five times the next largest CAD in 2007.  A common criticism was that US profligacy – high levels of spending and low levels of saving – led to a high current account deficit (CAD). But it is also possible to explain imbalances by looking at surplus countries and consider whether it is the capital account (financial flows) that explain imbalances rather than the current account (trade  and income flows). 

Many argue that what is required is a gradual rebalancing of global capital flows with the United States saving more and consuming less, and becoming less reliant on foreign investors to fund its CAD; and China and other surplus countries taking action to stimulate demand within their own economies. For the Chinese people to spend more requires them to save less. But this will not happen unless the Chinese government provides more certainty for the population through spending on public health and welfare. Both deficit and surplus countries will need to make adjustments and this will require deft negotiations.

It is possible that the global recession has forced some changes. The United States is attempting to reduce both consumption and debt, and China’s latest five-year plan advocates rebalancing the Chinese economy towards greater household consumption.

The danger is that a long-term unwinding of debt in the United States and other economies is likely to see a prolonged period of slow growth. Increased consumption in China is likely to be beneficial over the long term for the Chinese people but as the West buys fewer Chinese goods it should also mean (eventually) a period of adjustment for the Chinese economy.

A recent speech by Guy Debelle, "In Defence of Current Account Deficits" argues that imbalances should not necessarily be seen as bad. 

[T]he US current account deficit through the 2000s was the net balance of very large capital inflows and outflows. Much of the inflows were into either US treasuries or to US mortgage securities and related products, while a sizeable share of the outflow was foreign direct investment by US corporations. The US was able to earn relatively more on its stock of foreign assets than it paid on its foreign liabilities such that its net income position was often in surplus.Some of the flows were ‘bad’, at least ex post, such as those which found their way into poor-performing securities. However, very few were able to identify ex ante the distortion that was generating these ‘harmful’ flows. Other flows were clearly ‘good’. But the point to make is that focusing on the net balance of these flows, which is the current account position, is not particularly helpful relative to more scrutiny of the various components of the gross capital flows.

To justify his position he applies the logic of current account balances across generations and across the states in Australia. 

To mount a defence of current account deficits, I would like to provide a bit of context with which to think about this issue. One place to start is with an overlapping generations model of a closed economy, which we can think of as a country. Within this country there are households that are at various stages of their lifecycle. The younger working households save, the middle-aged households borrow, while the older households run down their stock of accumulated saving. So we have ‘imbalances’ across the household sector. The young households have current account surpluses, the middle-aged households like me are in current account deficit. But these ‘imbalances’ are not generally cause for concern. It would not be socially desirable if there were no cash flows between households.

Alternatively, we could consider the Australian states. At any point, there can be large current account positions between the Australian states. There are large financial flows across state borders too. Are we even aware that this is the case and should we be concerned? By and large, we should not. Again it is useful to think about why any such imbalances across the Australian states are not a cause for concern. Here we are straying into the optimal currency literature, most famously associated with Robert Mundell, which is currently getting a fair working over in the context of the problems of the European periphery.

Some of the reasons we are not concerned about the current account ‘imbalances’ of the Australian states is that the Australian states have a common currency, a federal fiscal system, sizeable interstate labour mobility (of which me and much of my Adelaide cohort are a good example of) and generally experience similar economic shocks.  These are the main prerequisites identified for an optimal currency area.

He argues that those who worry about a precipitous narrowing of the CAD imbalances. 

Such a scenario does not directly translate into a world of floating exchange rates. In that environment, the main mechanism of adjustment is the exchange rate. If global investors reduced their appetite for investment in a particular country, the exchange rate would depreciate until the point where investors would be happy once again with their allocation to the country in their overall portfolio. While the exchange rate might overshoot in this scenario, the depreciation is stimulatory to the economy, whereas in the fixed exchange rate world, the adjustment is contractionary.

In sum, Debelle's point is that the composition of the capital flows matters more than the imbalances themselves.

The conclusion I wish to draw then is that there can be perfectly good reasons why current account balances are not zero, and indeed can even be quite sizeable, without them constituting imbalances or being a cause for concern. The accompanying capital flows are often beneficial. This is not to say that they should not be scrutinised but rather that the scrutiny should really be on the nature of those capital flows to examine whether they are being driven by inappropriate policies or distortions.

The view that a CAD or imbalances are not a problem is particularly relevant for Australia, given that we have run deficits for long periods. Our deficits have been income driven, although trade factors have also been important. 

From the early 1990s until 2007, Australia recorded a current account deficit which averaged around 4¼ per cent of GDP. There were cycles around that level, with the current account narrowing to 2 per cent of GDP in 2001 in the aftermath of the Asian crisis and widening to around 6 per cent of GDP in 2007. 

At the same time, there was reasonable stability in the major components of the capital account. The inflow arising from the offshore funding of the banking sector was around 3½ per cent of GDP. This led to the common assessment that the Australian banking sector was ‘funding the current account’.

In my opinion, this analysis is incomplete. As mentioned earlier, a current account deficit and its equivalent capital account surplus is the net outcome of considerably larger gross flows. This is evident in Graph 1. Through this period there was substantial Australian investment abroad, particularly in the form of equity. Much of this was the result of the Australian superannuation sector investing a sizeable share of their funds in offshore equity markets. At times, there were also sizeable equity inflows to Australia.

Over the past few years, the composition of these capital flows has changed quite significantly, providing some contrary evidence to the hypothesis that the banks fund the current account. I don't think there was any particular problem with the structure of these capital flows previously, nor do I think there is one now.

In 2010, the net inflow to the Australian banking sector was close to zero (Graph 2). Indeed, over the last three quarters of 2010, the Australian banking sector was a net repayer of its offshore liabilities. That is, maturities exceeded issuance. This did not reflect a lack of appetite for Australian bank paper, as the cost of issuance was broadly flat or even slightly lower over the period. Instead, as I discussed in a recent speech, it reflected the fact that the banks had less need for wholesale borrowing given the conjuncture of fast deposit growth and subdued asset growth. The terming out of the banking sector's funding is also evident in the decline in the stock of short-term foreign liabilities but an increase in their longer-term liabilities.

 

This picture is reinforced if we include flows into Australian non-bank securitised assets (Graph 3). After net inflows amounting to around 1–2 per cent of GDP through the first half of the 2000s, there have been net outflows over the past three years. This change in net flows reflects the sharp drop-off in global appetite for securitised products as the problems in the US housing market came to the fore. The decline in demand for Australian securitised assets in part reflects the fact that a lot of the buyers of the paper pre-June 2007, structured investment vehicles, are no longer around.[¹²] Recent developments suggest appetite for these assets is growing again, both on- and offshore.

In 2010, while the banking sector's net offshore borrowing was zero, the current account deficit, while narrower than earlier years, was still 2½ per cent of GDP. An increase in foreign purchases of Australian government debt and decreased Australian investment abroad offset the decline in net capital inflow to the banking sector.

Turning to the current account side of the balance of payments, the notable development has been the shift in the trade balance from deficit to surplus as the much-commented-on rise in Australia's terms of trade has significantly boosted resource export earnings. In that respect, it is sometimes remarked that absent the terms of trade rise, Australia's current account would be markedly wider. But that ignores the fact that the exchange rate has also appreciated significantly alongside the rise in terms of trade, thereby reducing the boost to export earnings as well as causing changes in domestic absorption and production.

Another effect of the rise in the terms of trade has been on the net income deficit. Because a sizeable share of Australia's resource sector is foreign-owned, the increased income of that sector partly ‘leaks’ into a higher payment to the foreign owners, either in the form of dividend payments or retained earnings, thereby increasing the net income deficit. This also would not be occurring if the terms of trade were not at their current level.

A very interesting paper, indeed.

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