Imbalances Matter More than Ever
May 05, 2006
Stephen Roach (from Venice)
It is precisely because imbalances matter more than ever that I have changed my assessment of global macro risks (see my 1 May dispatch, “World on the Mend”). For me, the macro-analytic framework is the core of my value system as an economist. And the anchor of my global view has long been -- and continues to be -- the unsustainable imbalances that have opened up between the world’s creditors and debtors. That has not changed one iota. What has changed are the inputs that are fed into this thought process. They now point to a more benign strain of global rebalancing than I had previously thought. As Lord Keynes famously quipped, “When the facts change, I change my mind. What do you do, sir?”
The imperatives of global rebalancing have never been greater. By our reckoning, the disparity between the world’s current account surpluses and deficits will hit an astonishing 6% of world GDP in 2006. Moreover, the deterioration is occurring at unprecedented speed. If our forecast comes to pass, this year’s divergence between surpluses and deficits will be fully 50% higher than the 4% gap of 2003. And the asymmetry of the world’s imbalances remains one of its most problematic characteristics: The surpluses are broadly diffused, whereas the deficits are highly concentrated; last year, the US accounted for about 70% of all the current account deficits in the world. This asymmetry underscores the precarious nature of the global disequilibrium. With the three largest surplus nations -- Japan, China, and Germany -- all hard at work in stimulating internal demand, there is a growing likelihood that their surplus saving will decline. That will put even more pressure on the funding of the largest external deficit in recorded history. But why can’t this state of affairs persist indefinitely -- living up to its billing by some as the world’s first sustainable disequilibrium? This gets to the essence of the “new paradigm” thinking that has infatuated many in the world of international finance. In its simplest form, the so-called “Bretton Woods II” framework views Asia as part of an expanded dollar bloc. America, the consumer, is presumed to have a perfectly symbiotic relationship with Asia, the producer. The relationship is cemented by Asia’s quasi dollar pegs, which guarantee an automatic recycling of the region’s massive build-up of foreign exchange reserves into dollar-denominated assets. To the extent that this recycling pushes US interest rates lower than might otherwise be the case, asset-dependent US consumers enjoy a special subsidy from their foreign lenders. As depicted in this fashion, America’s consumption binge appears to match up perfectly with the Asian producers’ open-ended demand for dollars. Who could ask for more? To answer this question, it helps to simplify the world down to two major actors -- China and the United States. While the world in general and Asia, in particular, are full of export-led economies who recycle foreign exchange reserves into dollars, China is in a league of its own. Last year, China added about $200 billion to its reservoir of official currency reserves, and in early 2006, its holdings surpassed the $875 billion mark -- pushing it ahead of Japan as managing the world’s largest reserve portfolio. That’s an extraordinary leap. Just two years ago -- May 2004, to be precise --- Japan’s holdings of FX reserves ($817 billion) were fully 78% larger than those of China ($459 billion). There are several reasons why this state of affairs in not in China’s best interest: First, lacking a well-developed debt market, China has a hard time sterilizing its purchases of dollar-based assets. As a result, excess liquidity leaks into its financial system -- contributing to its bloated money supply and fueling froth in its asset markets, especially coastal property. Second, an educated guess puts the dollar share of China’s reserve portfolio at around 70%, or more than US$600 billion. Dollar depreciation in the 10-20% range would result in a sizable loss in the value of this position -- a distinct negative for China’s overall fiscal position. In this vein, Asian foreign exchange managers are waking up to the need to reassess their portfolio management practices. As Harvard President Lawrence Summers has argued, developing economies have parked a huge share of their some $2 trillion of “excess reserves” in low-yielding dollar-based bonds (see his 24 March 2006 speech, “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation”). By forgoing higher returns in alternative investments, poor countries are incurring outsized “opportunity costs” for the sake of keeping their currencies cheap enough to maximize exports to over-extended American consumers. Should the US consumer falter -- an increasingly likely probability -- this strategy will quickly backfire. Of all the developing countries in the world, China -- with its massive build-up of dollar-based foreign exchange reserves -- is most vulnerable to this possibility. Third, there is nothing symbiotic about anti-China protectionism currently working its way through the US Congress. Stable disequilibrium? Don’t bet on it insofar as China is concerned. The same can be said for the US. Although labor income (private sector compensation) is currently running about $340 billion in real terms below the profile of the typical expansion, the American consumer has pushed consumption up to a record 71% of GDP over the past four years. Property-driven wealth effects more than fill the void. In late 2005, Federal Reserve estimates put equity extraction from residential housing in excess of $640 billion. However, sustainability can be drawn into question on several counts: First, the US housing market has been pushed into bubble territory; in late 2005, fully 55 metropolitan areas were experiencing house price inflation of 20% or higher. With the housing market now rolling over, downside risk to equity extraction and wealth-dependent consumption can hardly be minimized. Second, aggressive equity extraction strategies have pushed household sector debt and debt service to record highs; with much of the newly originated indebtedness taken out at below-market “teaser” rates, the normal reset of lending terms is already pushing up borrowing expenses. Needless to say, a cyclical increase in interest rates -- a development that may now be starting to unfold -- would be all the more disconcerting for overly-indebted US consumers. Third, by replacing income-based saving with asset-dependent saving, consumers have left themselves heavily exposed to shocks; surging oil prices are a case in point -- hitting at a time when consumers’ saving rate is actually slightly negative, rather than the 8% saving rates which prevailed, on average, during the three earlier energy shocks. Chinese funding notwithstanding, the American consumer is hardly in a sustainable disequilibrium either. If mounting global imbalances are not in China’s or America’s best interests, it is only a matter of time before something pops -- and the sustainable disequilibrium quickly becomes unsustainable. Given the overhang of excess dollar holdings by poor countries, the flight out of dollars could be fast and furious. That could trigger the dreaded dollar-crash scenario and a related spike in real long-term US interest rates. Given the excess consumption and debt overhang in the US, a sharp pullback by the American consumer seems highly likely in such a scenario. This is the disruptive strain of global rebalancing that has long been my biggest fear. The dramatic widening of the US current account deficit to a $900 billion annual rate in the fourth quarter of 2005 -- fully 7% of US GDP -- was a warning shot to take this possibility seriously. I raised the volume in expressing these concerns in the past few months -- mainly because no one seemed to be listening. A new Federal Reserve chairman took over in the US who dismissed America’s imbalances as an innocent by-product of a “global saving glut.” The financial markets also seemed nonplussed -- especially after the dollar rose in 2005, after having fallen during most of the three previous years. I worried that the world was in denial just when imbalances were nearing the danger zone of maximum vulnerability. But then came the pleasant surprise -- the joint communiqués of the G-7 and IMF on 21 April. Suddenly, the case for global rebalancing was legitimized. No, an instant fix wasn’t offered for an unbalanced global economy, but a framework was proposed that gives the world a much better chance to find a collective resolution of this critical problem. That was not the only development that lowered my discomfort level. Two other central banks jumped on the normalization bandwagon -- the Bank of Japan and the People’s Bank of China -- and the Fed sent a signal that it was more interested in taking its policy rate into the neutral zone rather than into the more painful tightening zone. As a result, the tensions of the global rebalancing framework now stand a much better chance of being resolved in an orderly fashion rather than through a crisis. And so I have changed my assessment of global risks accordingly. There is, of course, no guarantee this will all work out in the end. I may well be guilty of giving too much credit to the stewards of globalization -- the G-7 and the IMF -- to find a workable solution. It’s one thing to have a framework that allows for shared responsibility in fixing an unbalanced world. It’s another thing altogether for individual nations to do the heavy lifting on economic policies that such responsibilities require. At the same time, the unbalanced world remains highly susceptible to any one of a number of shocks that seem to be lurking in the weeds. High oil prices, Iran, and protectionism continue to worry me the most in that regard. No, the world has not been healed of all that ails it. But because the powers that be have concluded that imbalances still matter, the urgency of global rebalancing is now center stage in the global policy arena. Call me less of a pessimist, or even an optimist if you wish, but that’s the best news I’ve heard in a long time.
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The Dollar and Inflation
May 05, 2006
Richard Berner (New York)
For a long time I’ve stressed what I see as upside risks to US inflation, primarily as homegrown cyclical inflation forces would get the upper hand over the secular factors holding inflation in check. But I thought that global forces also would play important roles. A declining dollar was an ingredient in helping the Fed fight deflation in 2003-04, although the extent of its influence is still hotly debated. But the secular influence of globalization, which exposed an increasing portion of the US economy to global competition, was a powerful offset. Coupled with the dollar’s appreciation through much of last year, the net effect was that inflation stayed tamer than I expected over the course of 2005. That was then. The dollar’s recent decline is now slightly tilting the balance of risks for US inflation higher, in my view. To be sure, the boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and also between import prices and consumer prices. But the empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years may reflect other forces holding inflation down. I suspect that the link varies with the cyclical state of the economy and inflation expectations. With those factors now tilting towards higher inflation, the dollar’s effect on inflation now could be larger than over 2002-04. A look at the 2002-04 episode and the statistical evidence bolsters the case for low and declining exchange-rate pass-through. On a trade-weighted basis, the Fed’s index of the dollar against 26 other currencies (the “broad” index) declined by 16% between the February 2002 dollar peak and the trough at the end of 2004, while the Fed’s narrower trade-weighted index against the major currencies slid by 23.4%. Import prices excluding fuels — which are obviously affected by factors other than the change in exchange rates — rose by just 4.3% over the same period. Narrower subindexes of import prices rose by similar or smaller amounts. Importantly, for example, the price index for imported consumer goods excluding autos rose by just 1.2% over that period. Regarding the link to consumer prices, “core” consumer commodity prices (in the CPI) stopped declining during the period, but the increase of 0.2% over the past year broadly illustrates just how low pass-through has fallen. The econometric evidence over a longer time frame also confirms the decline in exchange-rate pass-through. Several Fed economists in a recent paper find that the decline is a global phenomenon. Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al. “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006). That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year time period. And the further pass-through from imports to consumer prices has dropped to virtually nil during recent years. The authors attempt to control for cyclical forces by including output gaps in their equations. There are several likely reasons for the pass-through’s decline. Two stand out: First, monetary policy’s success in reducing inflation generally has offset any tendency for a weaker dollar to push up inflation; exporters to the United States have had to swallow some of the currency changes in profit margins. Second, and related, the globalization of markets and production has promoted “pricing to market” — that is, exporters not wanting to surrender market share have more closely matched domestic-origin prices in setting their export prices in foreign currency. The spread of multinational firms’ global sourcing and production has increasingly blurred the distinction between import and domestic prices of comparable finished goods. Both of these trends probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent. Importantly, the Asian financial crisis seems to have been a watershed event in accelerating the decline in the pass-through — cutting it roughly in half after 1997. Notwithstanding this evidence, four factors suggest that the dollar-inflation link may now be strengthening. First, while it is early days in the dollar’s recent slide — 5.6% against the major currencies and 3.9% against the broader group since the beginning of 2006 — the recent decline occurred over just four months, so the pace is roughly double that during 2002-04. A faster decline, especially if producers and investors are unhedged, could catch them off guard and promote increased pricing power. In contrast with the 2002-04 period, moreover, slack in both product and labor markets has ebbed significantly, global growth is stronger, and inflation expectations have edged higher. The dollar’s influence on US inflation depends on the cyclical state of the economy, and US industrial operating rates have jumped by 8 percentage points over the past four years, bringing them above long-term norms. The jobless rate has declined by 1.6 percentage points over the same period, and job opening rates have risen by 90 basis points to 2.7%. The cyclical reduction in economic slack suggests that, together with other factors, a further 10% decline in the dollar on a trade-weighted basis would help push US “core” inflation in terms of the PCE price index towards 2.5%. In addition, in the earlier period, global growth was close to trend and largely driven by US domestic demand. Today’s nearly 5% global boom entails more synchronous growth in non-US domestic demand. So the slack in the global economy may be ebbing as well. Finally, US longer-term inflation expectations seem to be edging higher: 5-10 year inflation expectations surveyed by the University of Michigan rose in early April to 3.1%, while distant forward breakeven inflation (5-year, 5-year forward BEIs from the TIPS market) has recently moved up by about 20 bp to 2.7%. None of those developments alone is worrisome; taken together, however, they add up to upside inflation risk. Market participants are trying to decide whether, with the Fed’s preferred measure of core inflation at the upper end of their comfort zone, slower growth will give the Fed latitude to end the tightening cycle. Inflation expectations are still relatively subdued, but both market participants and consumers are growing more concerned about inflation risks, judging by the data cited above. In my view, further significant dollar weakness at this juncture likely would escalate both inflation expectations and, courtesy of rising import prices, inflation itself. Last, while it seems that the threat of protectionism has cooled for now, following the visit of Chinese President Hu and with ample evidence that the economy and employment are still growing, a resurgence of protectionism could add another layer of risk to the inflation outlook. That’s because it would block competition in US markets from cheaper overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline, turning what has been a virtuous circle into a vicious one.
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The Structural Integrity of the 'De Facto Dollar Zone'
May 05, 2006
Stephen Jen (London) and Charles St-Arnaud (London)
The USD’s resilience depends on the dollar zone We remain cyclically bearish but structurally constructive on the dollar. We reiterate our call for 2006 that the USD will end the year modestly weaker. The focus of this note, however, is on a structural aspect of the USD debate. Specifically, we argue that the USD’s structural resilience, which is under intense scrutiny by investors, will be a function of the structural integrity of the ‘de facto dollar zone’. Our view is that the dollar zone will not break apart just because the Asian currencies will likely appreciate against the dollar. What holds the de facto dollar zone together is the inconvertibility of its member currencies, not exchange rate fixity. The ‘de facto dollar zone’ concept Our idea is based on the notion that many countries operate as if they are a part of the dollar area. What distinguishes our concept from the ‘Bretton Woods II’ idea is that our framework includes not only economies whose currencies are hard- or de facto pegged to the dollar, but also those that don’t yet have full capital account convertibility and are reliant on the USD for all accounting, invoicing and settlement purposes. The dollar zone includes: Japan, most of whose trade is still settled in USD and which has been sensitive to the relative competitiveness vis-à-vis the rest of Asia; Hong Kong, which is hard-pegged to the USD; and the rest of Asia ex-Japan (AXJ), which has managed float systems, but virtually all of its external trade and capital flows are conducted exclusively through the dollar. Similarly, the six members of the GCC are hard-pegged to the dollar and belong to the de facto dollar zone. We computed the trade deficit of this de facto dollar zone, by netting out ‘intra-dollar zone’ trade, based on 2005 data. If we include only the Asian countries in our sample, the trade deficit of the USD zone falls from 6.6% of GDP, for the US alone, to 2.7%. Further, if we also include the GCC countries, then the zone-wide trade deficit falls to 1.9% of GDP. While the US trade deficit of 6.6% of GDP sounds high, with globalization, shouldn’t 1.9% of GDP’s worth of trade deficit for the dollar zone be sustainable? Outstanding questions The basic conceptual framework of the de facto dollar zone may help explain why the dollar has been so resilient so far, despite the outsized US external imbalances in recent years and the overwhelmingly USD bearish sentiment in the market. Whether the structural integrity of this dollar zone will be preserved is a legitimate subject of debate. Questionable view 1. The G7 Communiqué was a clear indication that the G7 demands that the AXJ countries revalue their currencies, which would undermine the integrity of the dollar zone. Again, as we argued above, currency fixity is not central to the de facto dollar zone idea. The role of the dollar as an ‘international money’ has grown so much in this globalized world that it has, in a way, lost its national connotation. The dollar is increasingly the international unit of account and medium of exchange. These two roles should be further enhanced going forward. The symbiotic relationship between the US and members of the dollar zone is not limited to the goods market; it also applies to the capital markets. Questionable view 2. The Asian central banks are diversifying away from USD, which will undermine the integrity of the dollar zone. First, Sweden’s decision to raise its EUR holdings was due to the low volatility in EUR/SEK and high volatility in USD/SEK, not diversification away from the USD. Second, some Middle East countries may have begun diversifying their official reserves, but this could be politically motivated related to the Dubai World case. Third, some of the large Asian central banks have indeed been gradually diversifying their reserve assets: across assets as well as across currencies. However, IMF data on currency composition of foreign exchange reserves do not show any meaningful signs of wholesale diversification. Questionable view 3. The US prefers to use a weak dollar for political purposes. With the risk to inflation biased to the upside why would the US introduce another inflationary shock by driving the dollar lower? We do not believe that the US ‘secretly’ has a weak dollar policy or a weak dollar preference. It may have a ‘strong Asian currency policy’, but that is awkward for the Treasury to espouse. Bottom line We continue to believe that the USD should, and most likely will, weaken further, more so against Asia than against the European currencies. Nevertheless, we stress that this is a purely cyclical call. From a structural perspective, we remain constructive on the USD, and believe that the structural integrity of the ‘de facto dollar zone’ will be well preserved.
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Almost Perfect
May 05, 2006
Serhan Cevik (London)
Israel’s new government is good news for the economy and financial markets. The formation of a ‘grand’ coalition with a reasonable majority — 67 of the 120 seats — in the Knesset is a positive development that will help in maintaining economic stability and pursuing further withdrawals from the Palestinian territories, in our view. Though there might be some increase in ‘social’ spending, the new government is likely to remain broadly committed to fiscal prudence and structural reforms that have already lowered real interest rates and set the stage for strong economic growth in Israel. Political stability is key to macroeconomic stability in any country, but Israel is particularly vulnerable to the state of affairs in the occupied territories. Indeed, as the situation worsened over the decades, the growth rate of per capita income declined from an average of 5.5% per annum in the first 25 years to merely 1.4% in the aftermath of the Yom Kippur War in 1973. This is why we believe that the establishment of a strong government committed to peaceful resolution of the Israeli-Palestinian conflict as well as maintaining stability-oriented economic policies is necessary for achieving sustainable output growth and addressing the country’s socio-economic shortcomings (see The Return of Fat Years, December 12, 2005). The leading indicators point towards strong growth momentum this year. Real GDP increased by 4.3% in 2004 and 5.2% last year — well above the dismal performance in the previous years — and the latest set of indicators confirms the continuation of above-trend expansion in domestic economic activity as well as in exports. For example, the industrial production index posted an annualised increase of 9.2% in the first two months of this year, up from 4.6% in 2005. And, according to the recent survey of the corporate sector, industrial output will continue growing in the second quarter, thanks to increasing export and domestic orders. Likewise, with the gradual but sustained recovery in the labour market, retail sales expanded by 9.5% in 2005 and 7.7% in the first two months of the current year. As a result, reflecting robust growth in the global economy and accommodative domestic monetary conditions, the state of the economy index — a composite gauge compiled by the Bank of Israel — showed an average year-on-year increase of 6.4% in the first quarter, on top of a 6.6% improvement last year. All in all, the latest figures suggest that real GDP growth may even exceed our above-consensus projection of 4.5% this year. The Israeli economy, growing at an above-trend pace, is running out of spare capacity. As argued in our previous dispatches, the Israeli economy — enjoying above-trend output growth in the last three years — no longer has the excess capacity to absorb burgeoning domestic demand. Especially, the acceleration in business-sector GDP growth from 2.5% in 2003 to 6.3% in 2004 and 6.6% last year has narrowed the output gap and now allows companies to pass on more of the increase in energy and intermediate costs. Indeed, inflation, measured by the consumer price index, has already increased from 2.4% at the end of last year to 3.6% in March and is likely to stay above the upper limit of the central bank’s target range. Even though disinflationary forces in the global economy continue limiting the upside risks to inflation, the marked slowdown in productivity growth and the surge in energy prices clearly add to upward pressure on domestic prices. However, we do not expect an inflationary spiral, since the central bank has enough ammunition and the state of public finances remains supportive of price stability. The Bank of Israel’s monetary tightening campaign is not over yet, in our view. In the last eight months, the central bank has raised short-term interest rates by 175bp to 5.25%, which we estimate to be the ‘neutral’ level. Nevertheless, the current policy stance may not be enough — even with the recent strengthening of the shekel against the dollar — to keep inflation (and inflation expectations) anchored within the target range. In other words, given the pace of growth in domestic demand and the low level of real interest rates, the ‘normalisation’ of monetary conditions requires tightening of the policy rate beyond the point of neutrality to about 5.75% in the coming months. In our view, this is good news, not a threat, and would support shekel-denominated instruments.
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BoP Surpluses Won't Trigger Revaluation
May 05, 2006
Andy Xie (Hong Kong)
* Surging BoP surplus is insufficient to trigger revaluation. China’s balance of payment surplus was 9.3% of GDP in 2005 and 10.7% in 2004. This factor alone won’t trigger revaluation by China, in my view, as speculation accounts for most of the surpluses. * Revaluation won’t solve China’s problem. Weak consumption is the reason for China’s macro imbalance. There is low import content in China’s consumption. Wealth is concentrated in a small minority. Revaluation does not help consumption. * Improving household spending power is key to solving China’s macro imbalance. Shifting fiscal expenditure to social spending, increasing fiscal funding by issuing bonds and accelerating wage growth could solve China’s macro imbalance. * Only inflation can force China to revalue. China’s inflation rate remains low because investment drives growth. If inflation accelerates to destabilize the economy, revaluation may become necessary. Summary and conclusions Surging BoP surpluses due to rising trade surpluses and, more importantly, speculative capital inflow won’t force China to revalue the currency, in my view. Weak consumption is the main cause of China’s macro imbalance. Currency appreciation is unlikely to help consumption because the import content in consumption is low and wealth is concentrated in a small minority of the population. Only inflation could force China to revalue the currency, but labor surpluses are still keeping wage growth modest. The government has not solved the factors that keep household precautionary savings high, and overcapacity is ubiquitous. Therefore, inflation should remain contained. China’s macro situation is unique, due to the sharp differences between the Eastern Seaboard (Shanghai, Jiangsu, Zhejiang, Fujian, and Guangdong provinces) and the inland provinces. The former resemble Taiwan in the second half of the 1980s, with rapid productivity growth and massive balance of payment surpluses. The latter have low productivity and depend on sending labor to the coast for remittance income. The solution for China’s macro imbalance is to boost consumption. The exchange rate only becomes a policy option when China’s consumption reaches a normal level by international standards and the country still experiences a massive BoP surplus. The nature of the BoP surplus China’s balance of payment surpluses in the past three years exceeded all its previous surpluses. Between 2003-05 these totaled US$530.5 billion, or 9% of GDP per annum. During Taiwan’s peak years from 1985-87, it averaged 22.6% of GDP, and Thailand’s BoP surplus averaged 3.9% of GDP in 1988-95. China’s BoP trend bears some resemblance to what occurred in Taiwan and Southeast Asia in the late 1980s and early 1990s. As with other East Asian economies in the past, China’s BoP surplus is due to surging exports and capital inflows. The latter are driven by expectations of currency appreciation and the related property speculation. China’s BoP data are more difficult to interpret. Its exports are mainly OEM production by Taiwanese, Hong Kong and other foreign enterprises. Over- or under-invoicing is a common practice for arbitraging opportunities. In particular, the offshore NDF (non-deliverable forward) market for Rmb has become an attractive arbitrage place against Rmb appreciation expectations. The supply of Rmb in the NDF market, despite China’s closed capital account, is probably from over- or under-invoicing in the trade account. The massive flip-over between the financial account and trade account last year raises the possibility that capital flow for Rmb speculation masqueraded as a trade surplus last year due to improving capital account control. This is important in understanding the nature of China’s BoP surplus. 2005 BoP data suggest that capital account flows accounted for one-third of the BoP surplus, while 2004 data suggest that this was three-quarters. If 2004 data are more accurate, the appreciating pressure appears to be mainly a speculative phenomenon. When Taiwan’s BoP surplus surged in 1985-88, the current account accounted for 75% of the surpluses. In 1988-95, the Thai current account averaged 6.2% of GDP in deficit, i.e., speculative capital may have averaged 10.1% of GDP per annum. The difference in the BoP surpluses led to a different ending for Taiwan and Thailand in 1997 and 1998. This is why it is important to ascertain the true distribution of China’s BoP surplus. From my contacts with export companies, I believe that China’s trade surplus is overstated. Most export companies are suffering from rising costs. Many have got into property development to sustain profitability, and they may have engaged in Rmb arbitrage to keep profits up. China’s current account surplus in 2005 amounted to 7% of GDP. China’s household savings were probably about 17% of GDP. China’s gross savings rate was about 50% and net savings 31% last year. Considering that China’s investment rose by 80% faster than GDP in the past three years, it is hard to imagine that China’s savings surplus could rise so rapidly. When data are not accurate, economic views become guesswork. My judgment is that China has a current surplus of 3-4%, not 7% of GDP. China is between Taiwan and Thailand in terms of the nature of the BoP surplus. Inflation remains low despite BoP surpluses From 1988-95, Thailand experienced 4.9% annual inflation, and in 1988-92 Taiwan experienced 4.1% annual inflation The BoP surpluses did lead to inflation, as economic theory would predict. China experienced inflation of 1.2% in 2003, 3.9% in 2004 and 1.8% in 2005. One may argue about the data quality and, hence, the precise level of inflation in China. But, with excess capacity visible in many industries and moderate wage growth, it is reasonable to believe that China is experiencing low inflation despite massive BoP surpluses. There are three factors that explain China’s unique inflationary response to the BoP surpluses. First, the Eastern Seaboard essentially accounts for 25% of the national population, including migrant workers, but all the BoP surpluses. The size of the hinterland is so vast that labor movement is sufficient to keep wages contained. China’s statistics showed a wage increase of 14.9% in 2005, 14.1% in 2004 and 13% in 2003. Based on my casual observations, the data obviously look wrong. I recently visited a convenience store chain and a freight forwarder — both reported 5% wage growth last year. Mercer’s study shows 7-8% wage growth in the past two years in Beijing, Guangdong and Shanghai — the highest wage growth provinces — and expects the same growth in this area. Most non-rural workers have temporary jobs and their wages are not well represented in income surveys. A recent State Council report targeting this group showed that about 80% earned less than Rmb800 per month. Their income growth is probably slower than in the formal sector. Labor shortages in China have been a fashionable topic lately. But, it is not true, in my view. Hiroshi Inagaki of Mizuho Research Institute documented the data on the issue in his April 2006 paper (South China’s Labor Shortage – Will the Current Worker Shortage Escalate?). The paper found evidence of a shortage of young female workers but not other types of workers. The reason for the shortage is the massive growth of garment and electronics exports, which use such workers. This problem can be solved only through capital investment or sharp wage growth to attract such workers from the service sector. It does not represent general labor shortage at all. The concentration of Hong Kong and Taiwanese businesses that use such labor for export production is the cause. In addition to the labor surplus overhang, the role of government in China’s economic development has also contributed to the low inflation phenomenon in two ways. First, China’s reforms are anti-consumption. China’s urban disposable income survey in March 2006 showed that healthcare, education and housing accounted for one-third of expenditure and one-quarter of disposable income (Rmb1,140.11/person). Local governments and state-owned enterprises largely covered such expenditures before 1998. China’s reforms have shifted such burdens to the household sector and increased the profits of state-owned enterprises. The profits do not benefit consumption because the household sector does not own these enterprises. The anti-consumption bias in China’s growth model keeps inflation down. Second, local governments are effective in mobilizing revenues for investment. From selling land to attracting foreign capital, Chinese local governments are good at quickly building up productive capacity. The rapid supply response is the reason that temporary strong demand does not lead to an inflationary spiral. Indeed, the overcapacity tendency in China’s development keeps inflation artificially low and creates bad debts in a boom. Low inflation means the Chinese government does not have to revalue the currency despite surging BoP surpluses. China’s currency direction, therefore, is largely a political choice rather than dictated by the market. Property speculation coincides with BoP surpluses While inflation remains low, property speculation in China mirrors what happened in Taiwan in the late 1980s and Thailand in the early 1990s. Both quantities and prices advanced rapidly, which sparked worrying rumors about ‘empty flats’. The property bubble in Hong Kong in the mid-1990s and in New York and London now is primarily a price phenomenon without the scare stories about ‘empty flats’. In a price phenomenon, the property bubble affects the economy mainly via the wealth effect on consumption. When quantity is also a bubble, it affects the economy through investment demand and its multiplier effect on commodity industries. For example, the cement industry’s massive growth in Thailand in the 1990s was part of the property bubble. China’s property bubble is bigger than that seen in Taiwan and Thailand. Because China’s inflation is low due to the special reasons discussed, the liquidity from the BoP surpluses flows mainly into property. The quantity growth in Beijing and Shanghai has already exceeded what occurred in Bangkok during its property heyday. China’s central government has been tightening the property sector, mainly by increasing the cost of speculation and decreasing bank lending to the sector. However, as long as surplus liquidity remains, the bubble is likely to inflate again. China’s handling of BoP surpluses East Asian economies, which experienced massive BoP surpluses, all experienced painful hangovers when these dried up. Taiwan’s ‘empty flats’ haunted its economy and financial system for a decade. The Thai economy collapsed when the property market did in 1997. Other Southeast Asian economies — Hong Kong, Korea and Japan — experienced big current account and/or BoP surpluses. While all tried various ways to deal with it, nothing worked. From currency appreciation to anti-speculation measures, all suffered bad hangovers. Taiwan eventually appreciated the currency by one-third. However, this did not stop speculation. The property bubble finally collapsed when the ‘empty flat’ phenomenon eventually scared away investors. The trigger for Taiwan and Korea’s surging surpluses was the Plaza Accord that increased the value of the yen relative to their currencies. The surpluses caused massive property and stock market bubbles in both countries. Taiwan appreciated its currency by a third and Korea by a quarter in response to the surpluses and the resulting inflationary pressure. The hinterland effect keeps China from appreciating the currency quickly. It is trying anti-speculation measures that Singapore, Hong Kong and Taiwan tried at various points, but it is not clear whose approach was more successful. Singapore suffered less, but this was probably due to the high share of public housing rather than its 1995 anti-speculation measures. As with other East Asian economies, China is trying to muddle through handling the BoP surplus, i.e., when the property market becomes too hot, clamp down a little. The advantage of this approach is to prevent an imminent hard landing and sustain growth despite escalating imbalances in the economy. China will likely suffer a painful hangover as did its East Asian peers, in my view. Structural reform is the solution However, I believe that China does not have to suffer from a bad hangover. It can implement structural reforms to boost consumption demand, which could offset the negative impact from a property recession. First, China can increase the real effective exchange rate without moving the nominal exchange rate. Removing tax advantages for export production, increasing minimum wages and raising environmental standards could boost China’s real effective exchange rate by around 15%. This would convince the capital market to stop sending speculative money to China, in my view. Second, China can increase fiscal spending on social issues, boost wages and accelerate rural subsidies through issuing fiscal bonds. China’s household consumption is about 40% of GDP, but such measures could raise it to 50%. The consumption demand acceleration would be sufficient to buffer the negative effect from a property recession, in my view. Third, China could distribute government-owned assets among the people. It owns about 100% of GDP in assets, including state monopolies, land and natural resources. If these assets were shifted to the household balance sheet, this alone could raise the consumption to GDP ratio by five percentage points. Lastly, China’s financial system is government-owned and biased towards funding fixed investment, but this is being gradually reformed. When it becomes truly market-based, credit allocation will be more evenly distributed between investment and consumption. In short, China is suffering from BoP surpluses and is experiencing property speculation as other East Asian economies have done in the past. While the threat of a bad hangover looms, I believe that China still has room to boost consumption through structural reforms. China does not have to suffer a prolonged period of slow growth when the property bubble bursts.
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