A few years ago, Chris Dialynas and I wrote a piece which introduced the concept of “renegade economics”. It was derived from a Frank D. Graham’s 1943 essay titled, “Fundamentals of International Monetary Policy.” Graham, a Princeton University economist, wrote: “In international affairs we must therefore strive to reconcile the liberty of the individual, the sovereignty of states, and the welfare of the international community.” He understood that poorly crafted economic policies and rules in a global economy would lead to great imbalances that threaten stability and freedom. His analysis and insights applied to the two world wars of the last century as well as to the Great Depression.
But Graham’s insights, we noted in the article, were still relevant, notably in regard to China. Graham maintained that a poorly regulated fixed-exchange rate regime is inherently unstable. He argued that countries would cheat by setting their currency at rates that promote national agendas, ignoring the instability imposed upon the global economy. They become “renegade nations” in effect practicing “renegade economics.”
The nation which best reflects this description today is China. In response to Beijing’s mind boggling increase in real credit in the first half of 2009, Chinese fixed investment in industrial tradables rose dramatically . In the first phase of such an investment boom China’s imports had to rise, as the country needed capital goods and inputs for planned new industrial capacity. It takes many quarters to go from credit disbursements to the completion of new capacity and the initiation of new production. By the second quarter of this year some – but only some – of this new capacity began to come on stream. Further production responses to this new round of Chinese overinvestment lie ahead. When such capacity comes on stream there is a lesser need for imported capital goods and for the import and stock piling of inputs for planned future production. Instead, there is an onslaught of new production which targets export markets and which substitutes for prior imports.
The build-up of new production is undoubtedly a key factor behind China’s prominent rise to the world’s number 2 economic power. But because of the potential protectionist threat and the underlying fragility at the heart of China’s capex boom (along with the corruption of its political class), the change in status might prove to be ephemeral, much as Japan’s vaunted rise to number 2 ultimately gave way to a post-bubble morass which exists to this day in “The Land of the Setting Sun”.
Why the caution on China? For one thing, the recent surge in Chinese exports and even the reduction in Chinese imports reflect the first stage of the production onslaught from the industrial overinvestment triggered by the 2009 credit boom. There has been more of this in 2010, masked by a brief, but cosmetic change in China’s trade balance with the US last March. More recently, China has reported some disappointing economic numbers. They have been more negative than they look. China reports its statistics on a year over year basis, not on a sequential month to month or quarter to quarter basis. Year over year growth rates for many Chinese economic statistics have slowed somewhat, but remain very high. These are the growth rates that everyone focuses on. From this year over year data one can interpolate with some difficulty sequential month to month and quarter to quarter growth rates for these same economic variables. Based on calculations done by Lombard Street Research it appears that in July Chinese domestic demand may have gone negative in real terms. It was only a huge improvement in net trade that kept production growth significantly positive on a sequential basis.
Frank Veneroso, in particular, noted that the Asian PMIs have all started to turn down. The consensus has been that Asia would remain the strong part of the world economy. PMIs falling to 50 in several Asian economies may suggest otherwise. Obviously, much depends upon the Chinese economy. There have been signs that credit tightening in the first half of this year has led to something of a slowdown. Because of the endless flaws in the Chinese data it is hard to monitor sequential change in the Chinese economy. Both the government and HSBC PMIs from China have shown a significant industrial deceleration.
What leaps out are the declines in many Asian region PMIs all the way back down to the 50 level. Here is the most recent PMI from Japan.
The Korean industrial data still shows significant positive growth, albeit down from the spectacular growth several quarters ago. However, its PMI is also down to the 50 level.
Korean exports also appear to validate this caution over Asia.
They are released at the beginning each month and are the first to report in Asia (indeed the world, as far as we know) and the data quality is good.
The debate over a global slowdown will continue, but Korean exports suggest that the slide has already begun. September’s release showed Korean exports fell -13%m/m SAAR in August. This is the second m/m contraction, which does not happen that often for Korea; i.e., this could be statistically significant.
Some have argued that Korean exporters would be spared a slowdown due to a sharply weaker currency, especially against the JPY. Recall Japan is Korea’s main competitor. But this drop in exports appears to be happening despite a significant currency advantage, which again points to China as the potential culprit.
The same can be said of Australia and Taiwan where their manufacturing PMIs have fallen to 51.7 from 54.4 and 49.2 from 50.5 respectively.
It is difficult to gauge the significance of this purchasing data from Asia. Nonetheless, it is noteworthy that this PMI data may be suggesting more economic weakness in Asia than the consensus has anticipated. This might be due to a ‘beggar thy neighbor’ currency policy embraced by China, much as it did in the early 1990s, as well as the relentlessly weak U.S. economic data over the last several months, or a combination of both.
In such a context of seriously slowing domestic demand, largely in response to various kinds of credit restrictions imposed earlier this year, the new increment to Chinese industrial capacity and production must find a home in foreign markets. It is this process that has probably been in large part responsible for the surge in Chinese exports over the last two months. If so, as more and more of the new capacity comes on stream, short of a violent reversal in Chinese demand management policies, Chinese exports should continue to surge. A further increase in inbound container volumes into U. S. West Coast ports in July supports this expectation.
At the same time, the notion that China has responded to this favorable shift in trade balances by “revaluing” the currency is a classic smoke and mirrors game. For Beijing, it turns out that” increased flexibility” just meant “we’ll do a quick half-percent move so it looks like we’re doing something and we’ll just make it more volatile so we can screw the speculators”. This is something they must have learned that one from the French. In terms of cumulative appreciation since the announcement, we have pretty much flat-lined around 0.6%. In other words, the RMB is not looking not too different from the Hong Kong Dollar – a currency that is still officially pegged.
It therefore appears that all China did was to make a political gesture ahead of the G-20 meeting held last June They did not revalue. They did not widen the currency band. They were not specific about reforms. They have said the ratio of their current account surplus to GDP has been declining since the beginning of 2010, “with the BOP account moving closing to equilibrium, the basis for large scale appreciation of the RMB exchange rate does not exist.” That basically suggests they think little Yuan appreciation is needed. Hence, any Chinese revaluation going forward is likely to be similarly marginal and therefore a non event for the markets.
In one sense, that doesn’t give the whole story, given that wage and price pressures have already increased in China, thereby in effect “revaluing” the RMB via internal inflation. The recent rash of strikes in China and loud complaints from Chinese exporters over rising costs are testimony to a significant increase in the level of prices of inputs for manufacturers in China. If Chinese exporters of manufactured tradables experience a cost squeeze that cannot be good for Chinese corporate profits or the profits of its competitors in international markets for industrial goods, Chinese equities and equities elsewhere should suffer.
Of greatest importance, it is assumed by today’s market place that if the Chinese real trade weighted exchange rate revalues significantly, this would be a positive for the global economy. There is an idea out there that global imbalances in the form of excessive Chinese savings and excessive U.S. consumption has caused the disaster of the last several years. What have, in fact, caused these disasters are unprecedented global financial disequilibria resulting from myriad market bubbles, in part stemming from government policies in the U.S. and elsewhere that have fostered such bubble behavior. If China were to revalue significantly now they would increase the risks of more financial disequilibria largely because of the impact likely to be experienced in China itself, which could dwarf the situation that occurred in Japan, during its post bubble collapse.
The risk of consequent bursting bubbles lies in China itself. Today’s market participants have a belief that higher Chinese exchange rates will facilitate the transition from excessive fixed investment in China to more Chinese consumption. They seem to believe this will happen smoothly and that it will be a step towards stable global growth.
But as Veneroso has argued, throughout history, when fixed investment excesses have been reversed, there have been recessions. Fixed investment has never smoothly passed the baton to rising consumption. Whenever a fixed investment ratio has fallen from a high level there has always been an adverse multiplier into income and, therefore, into consumption. Check the historical record. There is little to support such optimism. The chances that China can smoothly transfer the growth baton from fixed investment to consumption should be less than in other historical instances. China’s current fixed investment ratio is higher than anything the world has ever seen.
In all economies and in all markets the greater the excess, the more severe the unwind. After all the bubbles and their bursting over the last fifteen years this should be obvious to everyone.
Throughout history the greater the fixed investment excess the more severe has been the subsequent recession when that excess was unwound. The fact that China has the greatest fixed investment excess ever suggests that, when it unwinds, there will be a nasty economic adjustment in China.
The more China experiences a revaluation of its real trade weighted exchange rate the greater the chances of a fixed investment downturn. A large part of China’s overall fixed investment and its excesses are in tradable goods industries. It is no secret that these industries are already being squeezed by rising domestic costs and China’s peg to a rising dollar. A further double-barreled push to a higher real trade weighted exchange rate from domestic inflation plus revaluation will seriously squeeze the self financing of industrial fixed investment. This will turn this part of overall Chinese fixed investment downward.
Can China pick up the slack with increases in fixed investment in housing and in infrastructure?
That is unlikely. There has been so much over building of real estate in China that the government has taken numerous measures this year to curb real estate speculation and over building. A reversal of this policy would simply shift the locus of unstable overinvestment from the industrial sector to the real estate sector which is unwanted by the Chinese policy makers and would probably prove to be unsustainable in any case.
What about infrastructure? It is always possible that China could decide to build even more infrastructure projects than it has already started. But there are impediments to this. Most of these projects are directed by state and local governments. According to many the state and local governments have borrowed to fund these projects through unorthodox channels and are now saddled with debts they may not be able to service. We have to remember that many of these infrastructure projects do not generate revenues that make them “self-financing”. It is possible that, over the long run, the central government of China may assume responsibility for the financing of these projects and use their control over money issue to assure their finance,
But so radical a step is likely to occur only after some unwind of China’s fixed investment excesses in the infrastructure sector have already created some damage.
As for the consumer quickly picking up the economic growth baton, there is no historical precedent for this. The fact that China’s consumption is such a small share of GDP makes it even more unlikely it could happen in a meaningful way in China. The fact that high income households who account for much of Chinese consumption have a huge exposure to Chinese real estate, which is a bubble, makes it even less likely that the Chinese consumer can pick up the baton amidst a downdraft in fixed investment.
The U.S. Congress was supposed to vote on China as a currency manipulator on April 15 of this year. As the date approached China’s trade account went suddenly, almost miraculously, and very transitorily into a deficit. This, plus efforts by the Geithner Treasury to avert “frictions” over the trade issue led to a deferral of that vote and an ultimate decision that China was not a currency manipulator.
Since then China’s trade account has gone back into a huge surplus and the U.S. trade deficit has widened dramatically, to some considerable degree as a result of trade deterioration with China. Obviously, the lawmakers and politicians who wanted to brand China as a currency manipulator and backed off because of the change in the Chinese trade balance this past March are likely to now want to bring the Chinese trade and currency issues back to the table. Additionally, since April the U.S. economic data has deteriorated in a relentless fashion. We are probably not yet in a double dip recession, but at a minimum the odds favor slow enough economic growth which, if not increasing unemployment, will certainly fail to reduce it. U.S. trade deterioration has contributed to this growth slowdown. The odds are great that, if the unemployment rate rises, there will be greater political pressure to do something about the adverse impact of China’s “mercantilism” on the U.S. economy and unemployment
Obviously, if the U.S. goes into a double dip recession and unemployment soars, the China trade issue is likely to become a politically very pressing one, especially during the heat of mid-term elections.
The Chinese at home face a dual bubble in real estate. There is a price bubble. According to the NBER, the real inflation adjusted price of land in Beijing has increased eight fold since 2003 – most of it in recent years. There have been similar though lesser land price bubbles in other cities. There is a quantity bubble as well. There are estimates that many tens of millions of apartments and other dwellings in China are vacant, suggesting a supply glut and vacancy rate beyond those experienced in other notorious quantity property bubbles elsewhere in Asia. These property price and quantity bubbles have gotten much worse over the last year and a half as a result of the unprecedented real credit expansion launched by the credit authorities in early 2009.
In addition, to these two bubbles in property in China there is clearly overinvestment in many industrial sectors in China. There is also an infrastructure bubble in the sense that many local authorities have embarked on massive projects which they are unable to finance through traditional channels.
Faced with these multiple “bubbles”, the Chinese authorities have been trying to reign in price and quantity bubbles in the real estate sector, have been trying to curtail capacity in some heavy industries, and have been trying to limit unconventional and often illegal financings by local authorities. All of these point to some degree of restraint on domestic demand. Given such restraint and the now programmed surge in the capacity to produce industrial tradables the odds are that China cannot afford a reversal in its widening trade surplus, since that would leave large swaths of industrial capacity idle and threaten employment as well as the absorption of migration from rural areas to urban centers. In other words, given the fact that the credit boom of 2009 has lead to serious overheating, China will try to restrain “pockets” of excess demand and is therefore going to be loath to take measures that would stop its export juggernaut and its substitution of imports.
This combination of growing U.S. political discontent over the U.S./China trade deficit and China’s need to put its latest round of fixed investment in industrial tradables to use in the context of domestic demand constraint puts U.S. and Chinese politics as regards trade on a collision course.
Economists and policy makers in the United States regard protectionism that might arise out of such a political impasse as a grave threat and danger to the world economy. But is this really true as regards the U.S.? That is not borne out by history, according to Peter Temin’s “Lessons from the Great Depression”.
Many blame a good part of the Great Depression on the Smoot Hawley legislation passed in 1930. But Temin notes that during the 1930s, the Smoot Hawley legislation hurt countries like the U.S. which had large export surpluses and were large net creditor countries. It did not hurt countries that were on the other side of those trade surpluses and external credits, such as the UK.
What would happen if there was a trade war between the U.S. and Asia today? U.S. consumers might find their goods slightly more expensive at Wal-Mart if U.S. companies did not manage to move the locus of their offshore production from China to other low cost countries fast enough. Would that really be so grave a loss to the U.S. economy? Asia has conducted mercantilist policies at the expense of Asian consumers for decades, and the investment world regards it as having been a successful strategy. Would it be a disaster for the U.S. if U.S. consumers had to pay a little more for their goods, but more of those goods might be produced once again back home, thereby reviving the U.S. industrial base?
If one simply looks at the numbers, in a trade war the U.S., with a low share of industry in its GDP, would be hurt far less than Asia with a very high share of industry in its GDP.
This sentiment has now been seconded by Nobel Laureate Paul Krugman who typically has the guts to challenge the orthodox consensus when it makes no sense. Krugman in effect backs the thesis set out by Peter Temin.
My colleagues believe that we should lecture the Chinese on what a bad thing they’re doing, but not actually threaten sanctions, lest we start a trade war. My belief is that this gets us nowhere. …
I say confront the issue head on – and if it leads to trade conflict, bear in mind that in a depressed world economy, surplus countries have a lot to lose from such a conflict, while deficit countries may well end up gaining.
There is another hypothesis I have mentioned in the past. Shocked by the sharp outright contraction in the Chinese economy at the end of 2008, Chinese authorities embarked on a credit driven investment boom which has no precedent in economic history. Much of this extraordinary increase in fixed investment has been in residential construction and infrastructure. But some of it has been in industry. Such a huge degree of overinvestment in industry in China should lead to much greater capacity to export industrial tradables and to substitute prior imports of industrial tradables.
In effect, China should become a far more formidable global competitor as the new investments come on stream. Who loses in this competition? It seems to me that the other mercantilist nations of Asia should be losers as China competes more ably for their export markets and substitutes for earlier booming imports sourced from these neighboring economies.
So it may be that, in response to record overinvestment in the largest mercantilist economy of them all, the other Asian mercantilist economies may now be starting to feel the adverse impact of greater Chinese competition.
THIS WOULD BE IN EFFECT BE VERY SIMILAR TO WHAT THE EAST ASIAN ECONOMIES EXPERIENCED IN THE MID-1990S, ABOUT 2 YEARS BEFORE THE ACTUAL START OF THE ASIAN FINANCIAL CRISIS.
China began devaluing its currency in 1992 and did so again in 1994 – a cumulative devaluation of 60%. This basically helped to put the East Asia economies in a terribly uncompetitive position, which culminated in these huge current account imbalances by the mid-1990s, ultimately setting the stage for the Asian financial crisis.
Will the lag be as long as was the case in the early 1990s? Highly unlikely, given the depressed state of the global economy and fact that China’s capex bubble is much more extreme. Protectionist pressures could well intensify and we could therefore see China experiencing big problems by next year.
If the U.S. flirts with a double dip or worse and unemployment rises and if China maintains some degree of demand restraint, sticks to the dollar peg, and maintains a wide trade surplus with the U.S., there are going to be serious trade frictions and possibly multiple rounds of retaliation. Forget Smoot-Hawley. This will not be terribly adverse for the U.S., but it will be very adverse for mercantilist Asia which is currently the regional favorite among risk seeking investors. In fact, China, not the US or Europe, could well represent the next major epicenter of financial instability. We have written before that China will soon be perceived as the rogue nation of the world, a scourge that is hurting everyone else. It appears that the new round of overinvestment is so great in percentage terms and is from such a large base it will likely have a big impact on global trade. The Chinese build their plants twice as fast as we do. So it takes about six months to two years to bring them on. The mega investment probably started around mid 2009. Some of this has already come on stream – hence, the surge in the Chinese trade surplus and the concomitant deterioration in the US trade deficit.
BUT the key point is that much of that 2009 vintage investment has not come on stream yet. On top of that is the ongoing over investment from the 2010 vintage and so forth. The global economy has not yet experienced the full brunt of this latest capital expenditure boom and is unlikely to do so until the middle of next year.
Going forward, China will be perceived more and more as a “strategic competitor”, particularly as import substitution policies intensify. So we are seeing the beginning but just the beginning of the damage that will be done to others by this rogue nation. This could well represent a major fault line in the global economy in 2011. What everyone is missing is that the real motive for the Chinese over-investment boom is that the party officials and all their cronies are making extraordinary riches in an extraordinarily quick period of time from this so called economic development – so rich that they do not care how it all ends. And that is why this madness will go on until it blows up or hits a brick wall. But this is likely problem for 2011. And when that happens, it is conceivable that all of the commodity bulls who think we can just "accumulate real assets" instead of "worthless fiat currency" will be experiencing the pain from this as much as anybody. And China could quickly find itself falling down the world rankings list from number 2 pretty quickly.