capital account flows Archives - the patient investor %

August 22, 2015

China’s dangerous currency manipulation

I am surprised at John Mauldin’s view in his latest newsletter Playing the Chinese Trump Card:

….This whole myth that China has purposely kept their currency undervalued needs to be completely excised from the economic discussion. First off, the two largest currency-manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands-down leading manipulator would have been the Federal Reserve of the United States.

John is correct that China has in recent years engaged in less quantitative easing than Japan, Europe and the US. And these activities are likely to weaken the respective currencies. But what he ignores is that these actions are puny compared to the $4.5 Trillion in foreign reserves that China has accumulated over the last decade. That is almost 2 years of goods and services imports — far in excess of the 3 months of imports considered prudent to guard against trade shocks. Arthur Laffer highlights this in his recent paper Currency Manipulation and its Distortion of Free Trade:

Foreign Reserves

Accumulation of excessive foreign reserves is the favored technique employed by China, and Japan before that, to suppress currency appreciation over the last three decades. Dollar outflows through capital account, used to purchase US Treasuries and other quality government and quasi-government debt, are used to offset dollar inflows from exports. This allows the exporting state to maintain a prolonged trade imbalance without substantial appreciation of their currency. And forces the target (US) to sustain a prolonged trade deficit to offset the capital inflows. Laffer sums up currency manipulation as:

….. when a country either purchases or sells foreign currency with the intent to move the domestic currency away from equilibrium or to prevent it from moving towards equilibrium.

Even Paul Krugman (whose views I seldom agree with) has been wise to the problem for at least 5 years:

…..economist Paul Krugman and a group of senators led by New York Democrat Chuck Schumer wanted to impose a 25% tariff on Chinese imports.

Prolonged current account imbalances cause instability in global financial markets. A sustained US current account deficit was one of the primary weaknesses cited by Nouriel Roubini in his forecasts of the 2008 financial crisis (the other side of the equation was a sustained Chinese surplus). But currency manipulation is not only dangerous, it is also short-sighted. International trade is a zero-sum game. For every dollar of goods, services, capital or interest that goes out, a dollar of goods, services, capital or interest must come in. For every country that runs a current account surplus, another must run a deficit. Without international regulation, each country will try to engineer a trade surplus in order to boost their domestic economy at the expense of their trade partners. An endless game of beggar-thy-neighbor.

Participants will suffer long-term consequences. The power of financial markets is unstoppable. Central banks attempt to hold back the tide, distorting price signals and shoring up surpluses (or deficits), at their peril. The market will have its way and restore equilibrium in the long term. As Japan in the 1990s and Switzerland recently experienced, the further you move markets away from equilibrium the more powerful the opposing backlash will be. The scale of China’s market manipulation is unprecedented, and caused large-scale distortions in the US. The end result forced the Fed to embark on unprecedented quantitative easing which, in turn, is now impacting back on China.

The impact will not only be felt by China, as John points out:

The low rates and massive amounts of money created by quantitative easing in the US showed up in emerging markets, pushing down their rates and driving up their currencies and markets. Just as [governor of the Central Bank of India, Raghuram Rajan] (and I) predicted, once the quantitative easing was taken away, the tremors in the emerging markets began, and those waves are now breaking on our own shores. The putative culprit is China, but at the root of the problem are serious liquidity problems in emerging markets. China’s actions just heighten those concerns.

Chinese hopes for a soft landing are futile.

February 9, 2015

Sectoral imbalances: Where have all the jobs gone?

Great post on Twitter from Naufal Sanaullah depicting US sectoral balances using UK economist Wynne Godley’s analytical framework.

Godley Sectoral Analysis

The key to understanding Godley’s analysis is that the sum of the four sectors is always zero. If one sector runs a deficit, it must be funded by a surplus in another sector — and vice versa. For example, if the government runs a deficit (i.e. spends more than it collects by way of taxes) it must borrow the shortfall from another sector — either the private sector (business or households) or foreign investors.

The federal government has run consistent deficits since 1970, apart from a short interval during the Dotcom era. Deficits were expanded massively during the GFC (2008 global financial crisis) to rescue the economy from a contraction in aggregate demand which, if left un-checked, would have resulted in a deflationary spiral on a scale similar to the 1930s. The government deficit was funded by private (household) saving until the early 1980s. Thereafter, household savings shrunk, gradually replaced by foreign investment. More on this later.

The business sector oscillated between deficit (i.e. borrowing more than they earn) and surplus until a massive investment splurge during the Dotcom era. Deficits by the business sector are not a real cause for concern, provided that borrowed funds are used to make productive investments. Unfortunately that was not always the case in the Dotcom era. Of far greater concern was the large surpluses run during the GFC, when the private sector stopped investing and used savings to repay debt. That is the major reason for the output gap (or GDP gap as it is sometimes called) and slow recovery depicted below.

One of the positives to come out of the GFC has been the resumption of household savings — a healthy sign in the economy if not carried to excess. But there are two glaring negatives.

First, the Federal government has been racking up public debt, kicking the can down the road since the 1970s with little effort to address the imbalance. When private sector savings dwindled in the 1980s, a new player appeared. Fiscal deficits were increasingly funded by foreign capital inflows, allowing government to deliver benefits in excess of taxes collected — like the sugar-plum fairy — without taxpayers being aware that the debt millstone around their necks was rapidly growing. Apart from a brief Clinton-era surplus, during the private sector Dotcom splurge, this has been going on for more than four decades — and is unlikely to change until Americans fix their political system.

A second threat is foreign capital inflows, shown in purple on the graph, which commenced in earnest with Japanese purchases of US Treasuries in the 1980s but reached a ‘nuclear’ scale when China joined the party in the early 2000s. While it may appear fairly benign, with foreign investors stepping in to lend Uncle Sam a helping hand, the damage is insidious. Foreign capital inflows are a major cause of the dwindling household surplus. Far from a friendly loan, these capital inflows were intended to undermine the competitiveness of US manufacturers in both domestic and export markets through currency manipulation.

Foreign Direct Investment in US

To understand how currency manipulation works, we need to examine the foreign surplus in more detail. There are two parts to currency flows between nations: the current (income) account and the capital account. The current account comprises the trade surplus or deficit (the net sum of all trade flows between the two nations) and the smaller net income flow from investments.

Current Account Balance

The capital account reflects all capital flows, whether investment or loans, between the two countries. Again, the sum of the two is always zero. If there is a deficit on the current account (money flowing out), there must be a surplus on the capital account (loans and investments flowing in) to restore the balance. If not, and Japan/China had to increase their exports to the US without a reciprocal flow of capital, the value of the dollar would plummet against the yen/yuan until the trade balance was restored.

Think of it this way. If an importer in the US buys goods from China, they must purchase yuan to pay for the goods. If there are more imports than exports, the demand for yuan will be higher than demand for dollars; so the yuan will rise against the dollar until demand matches supply. But what currency manipulators do is invest money via capital account (mainly in US Treasuries), purchasing dollars to soak up the shortfall so that their currency doesn’t appreciate despite the massive trade surplus with the US.

The impact of this is two-fold. First US manufacturers shed jobs as they lose market share in both domestic and export markets. That cuts into the household surplus as unemployment rises and real wages fall. Second, the US government runs bigger deficits to make up for the demand shortfall in order to buoy economic growth. The end result is that US taxpayers grow poorer — as the size of the public debt millstone increases — while currency manipulators grow richer. The debt binge that led to the GFC was largely fueled by foreign capital inflows. The fact that this imbalance has been allowed to continue is a damning indictment of political leadership in Washington. There is no way that they can be unaware of the damage being caused to US manufacturers, households and to public finances. Change is long overdue.

October 7, 2014

Reserve currency status: Privilege or burden?

Is the reserve currency status of the US Dollar a privilege or a burden? Michael Pettis suggests the latter and argues in favor of constraining unlimited purchases of US or other government bonds by international trading partners like China and Japan:

…it is actually quite easy to list the conditions under which reserve currency status encourages growth and the conditions under which it forces a rise either in debt or in unemployment. In advanced countries with deep and flexible financial markets, except in the case in which capital has become severely constrained by the need for money to be backed by gold, or real interest rates have been forced up to extremely high levels in order to break inflation as was the case in the late 1970s and early 1980s, the net inflows associated automatically with reserve currency status will not result in an increase in productive investment. They only result in an increase either in debt or in unemployment.

This is not an argument in favor of returning to gold, by the way. It is completely neutral on the issue. This argument simply restates the Keynesian insight that eliminating the discipline imposed by the gold standard is likely to become destabilizing unless there is another way to impose discipline…..

….the potentially destabilizing effect is no longer so distant. In a recent essay I tried to show that if we have not already reached the point at which the dominant reserve currency status of the US dollar is harmful to the US and potentially destabilizing to the world, logically we will inevitably reach that point, and probably soon….

I have frequently argued that capital account inflows into US Treasuries artificially inflate the dollar, give trading partners a competitive advantage, and cause the loss of millions of manufacturing jobs. Failure to address this issue is one of the major causes of low wage growth and rising inequality in the US.