Thursday, July 15, 2004

China Watch: Soft Landing or Hard?

The other day, the oldman was reading Investor Business Daily at the newstand and he saw an article describing how China was engineering a soft landing. However key to that observation was that it stated that China needed its export markets to the USA to stay strong to take up the load from the slowing domestic economy or the landing would be hard and not soft.

Like much else commentary out there, it lacks context that would allow real decision making. Some context can be found here at the Taiwan-News that describes a not quite as large current accounts deficit as before.

U.S. trade deficit narrows to US$46b

2004-07-15 / Associated Press /
America's trade deficit narrowed to US$46 billion in May, an improvement brought about as U.S. exports posted their best month on record.

The latest snapshot of trade activity, reported by the Commerce Department on Tuesday, came after the deficit had mushroomed to an all-time monthly high of US$48.1 billion in April. The 4.5 percent reduction in the deficit during May represented the largest over-the-month decrease since October 2002. The decline was the first after five straight months of increases.

"It's nice to have some good news," said Clifford Waldman, economist at Manufacturers Alliance/MAPI, a research group. "Export activity is getting more buoyant."

The trade deficit figure for May was better than some analysts were expecting. They were forecasting the deficit to hold fairly steady. The narrowing of the gap in May resulted from export growth far outpacing imports, which still climbed to a record high.

Exports of U.S. goods and services rose to a record US$97.1 billion in May, representing a sizable 2.9 percent increase from April's level. Exports were helped by a weaker dollar, which makes U.S. goods cheaper for foreign buyers, and a pickup in overseas economies.

Imports, meanwhile, increased by 0.4 percent to US$143.1 billion in May, reflecting Americans' voracious appetite for foreign-made goods.

So that's good news for the USA and bad news for China? Not quite. Remember that by all the indicators we've seen, the economy peaked in May and began sliding in June. The current accounts number is a lagging indicator if only because they release it in such an untimely way. Furthermore, we can see that the general trend doesn't apply to Chinese imports.
By country, America's politically sensitive trade deficit with China widened to US$12.1 billion in May as imports from China climbed to US$15 billion, the second-highest level on record. The record occurred in October 2003, when imports from China totaled US$16.5 billion.

The Bush administration has been pressing Beijing to stop linking its currency to the dollar and to let the value of the yuan be set in open markets.

This is of course a bluff by the Bush Administration for the consumption of people back home. If Asian banks stopped buying US Treasuries interest rates would rise almost immediately and the dollar would tumble. Of course if that happens the export market to the US from China would shrink. Causing the soft landing in China to be converted to a hard landing.

Now previously I said that China was likely to have a hard landing. It's moderate credit tightening policies in the short term seem to have produced a slowing but not dampening of economic growth. However one has to realize the system is interactive. The real reason I mentioned before the Chinese economy was so unstable was that it had become coupled to ours. But don't take my word for it, listen to The Economist here.
The dollar's recent decline may seem puzzling, for it began while expectations were mounting that the Federal Reserve was about to put up interest rates. The decline has continued since those expectations were confirmed on June 30th. Rising interest rates, you might have thought, would halt any such decline.

That is true only up to a point. As the American economy brought forth jobs in the spring, and the markets started to expect that the Fed would increase rates sooner rather than later, the dollar was boosted. A prime reason was that traders who had previously borrowed greenbacks in order to exchange them for other, higher-yielding currencies now needed to buy them back in a hurry. Lately, however, softer economic data have sown the idea that the Fed might not have to raise rates so far and fast after all. That has done the dollar no favours in recent days.

In the longer term, though, higher interest rates may be a curse for the dollar, not a blessing. To see why, look at that large and growing thing that goes under the name of America's current-account deficit. A country's current-account essentially comprises two things: the trade balance and net income from foreign investments. America runs a trade deficit that in April amounted to $48.3 billion, up from $46.6 billion in March. This alone implies an annual deficit pushing $600 billion, or 6% of GDP. The current-account deficit would be greater still if America did not make more money on its investments abroad than foreigners earn in the United States.

That it makes a profit is odd, because it has net foreign liabilities (ie, the value of Americans' assets abroad is less than that of foreign claims on America). According to the Department of Commerce's Bureau of Economic Analysis, net liabilities amounted to 24% of GDP last year. America has an investment-income surplus because yields are much lower at home than abroad. All things equal, says Goldman Sachs, a yield of 6% on ten-year Treasuries would add 1% of GDP to the current-account deficit within a few years.

Economists fret about America's current-account deficit because it is a measure both of America's ability (or inability) to save and its attractiveness to foreign investors. The country's heady growth of recent years has relied on foreigners' willingness to invest there: Americans, in effect, spend other people's money. That need not matter when the sums are small, but it does when they are large and getting larger. Most economists believe that at some point the dollar will need to get cheaper, maybe much cheaper, to encourage foreigners to finance the deficit. That point may be at hand. [emphasis added]

So the actual play in motion is that the dollar is poised for a potentially precipitious decline, one that can either only be restrained at best marginally by higher interest rates (since the economic contraction from higher interest rates would contribute to lowered dollar performance expectations as well) or a rapid fall in the dollar level arrested only by massive purchases of US Treasuries. That would create monetized inflation, perhaps even hyperinflation. The only choice would be how to distribute it. Either the Asian banks could let us free fall, and we would experience hyperinflation here. Or perhaps they would try to prevent the fall, and experience a hyperinflation or "hard landing" economic contraction over there in China, etc. Or perhaps they would intervene just enough to stabilize the situation and sort of spread the inflation all around.

These are the very same alternatives the oldman outlined earlier at some length, and now they're happening. The Economist unhappily concurs.
In recent years, the current-account deficit has instead been financed by (less stable) portfolio flows into stocks and bonds. In the past year, three-quarters of such investment in America has gone into bonds. The biggest buyers have been Asian central banks, trying to keep their currencies from rising too swiftly against the dollar (or maintaining a fixed rate, in China) and parking the money in Treasuries.

But this intervention has had a cost: inflation. Because the central banks bought the dollars with newly minted local currency, inflationary pressures have risen throughout Asia. This is fine for Japan, which has deflation, but not for its neighbours. Intervention thus seems to have stopped; even Japan turned off the tap in March. The central banks might, of course, wade back in if their currencies rose too much. But given the risk of inflation, it would be brave to bet on this. And if they do not buy the buck, who will?

In the short term, if they fail to support the dollar we will begin seeing true inflationary pressures in the United States. The good news is the current accounts deficit will narrow. The bad news is that the reverse of what we've enjoyed for many years - cheap consumer goods - will happen as prices rise across the board. Which of course they're already beginning to do. A truly huge wave of monetized inflation will crash through the economy and sink it. Of course there are varying degrees of intervention by China et al. that can distribute the pain differently between regions and the scylla of contraction and the charybdis of inflation but it's just a choice of poisons. Which one do you prefer?


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