trade deficit Archives - the patient investor

May 14, 2022May 14, 2022

Current turmoil and its impact on Gold

Michael Every from Rabobank is bearish on Gold in his recent video:

“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”

Several readers have written, asking if this changes our view on Gold.

The short answer is NO, for three reasons:

1. The Fed can only hike rates until something breaks

Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.

The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.

Bank credit still grows at a healthy rate.

Bank Credit & Fed Funds Rate

The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.

Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.

Copper-Gold Ratio & 10-Year Treasury Yield

Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).

Unemployment & Consumer Sentiment (inverted scale)

Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.

Investment Grade & High Yield Corporate Bond Issuance

A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.

2. A strong Dollar is destroying US industry

The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.

Foreign Debt & Current Account

This has allowed the Financial sector to grow to a point where it dominates the US economy.

Market Capitalization: Financial/Non-Financial Sector

Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.

In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.

Trade Deficit

The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.

The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.

Manufacturing Jobs & Current Account

The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.

GDP/Non-financial Debt

Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.

The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.

Foreign Held Federal Debt & Current Account Balance

3. US debt above 120% of GDP would destroy the bond market

Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.

Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.

That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.

Federal Debt/GDP

The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.

Federal Debt & GDP growth

Current turmoil

The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.

China & the Dollar

After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.

China: Foreign Reserves

China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.

Trade Weighted Dollar

The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.

China: Yuan

In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.

The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.

The Belt-and-Road initiative

In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).

China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.

China: Foreign Reserves

The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.

Funding the federal deficit

China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.

Externally Held US Treasuries - Major Holders

But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.

The US is faced with a difficult choice:

Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.

It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.

China

Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.

Chinese Ports

Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.

Chinese LNG Demand

Team USA

This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:

Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.

Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.

There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.

Conclusion

Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.

It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.

The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.

The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.

Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.

Acknowledgements

Tom Mclellan for the Unemployment/Consumer Sentiment comparison
Frankoz for the BRI insight

June 4, 2015

Australian exports hammered

This chart from Westpac highlights Australia’s export misery:

Iron ore Exports and Earnings

Iron ore prices are falling faster than shipments are rising. Andrew Hanlan sums up the the problem facing the Australian economy:

A jump in imports coincided with a sharp fall in export earnings. Critically, the rest of the world is paying us considerably less for our key exports, iron ore and coal. This negative shock is squeezing incomes for businesses, households and government alike.

April 21, 2015

US-Asia trade imbalance

Westpac produce a very detailed chart pack on the US economy called Northern Exposure. One item that stands out like a sore thumb is the trade imbalance between the US and Asia:

US External Trade

The trade balance between most countries and the US is close to equilibrium, where imports match exports:

Mexico: 2% surplus
UK: 1% surplus
Eurozone: 1% deficit
Other: 2% surplus

But there are three notable exceptions:

China: 15% deficit
Japan: 3% deficit
Canada: 9% surplus

Any large trade imbalance should cause the exchange rate between the two countries to rise or fall, making the exports of the net exporter more expensive and imports from the net importer cheaper, until balance is restored. But this has not happened with China and Japan. They are manipulating the system: investing a large portion of their trade surplus back in the US through the financial account, so that trade flows in one direction are offset by capital flows in the other. Their actions are clearly visible in the growth of Rest of World investment in US Treasury securities.

Holders of US Treasury Securities

That is the reason why the US consistently runs massive trade deficits and why the manufacturing sector has been shedding jobs for the last two decades. This could be prevented if the US was willing to regulate capital flows on the financial account: “we will open our capital markets to you if you open yours to US investors”.

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.

July 1, 2014

Full Employment and the Path to Shared Prosperity | Dissent

Great summary of the current political gridlock by Dean Baker and Jared Bernstein:

There are many policies that can reduce inequality, but there is none as straightforward conceptually and as difficult politically as full employment. The basic point is simple: at low rates of unemployment, the demand for labor allows workers at the middle and bottom of the wage distribution to achieve gains in hourly wages, annual hours of work, and thus income.

Levels of unemployment are not the gift or curse of the gods; they are the result of conscious economic policy. The decision to tolerate high rates of unemployment is a choice. It is one that has enormous implications not just for the millions of people who are needlessly unemployed or underemployed but also for tens of millions of workers in the bottom half of the wage distribution whose bargaining power is undermined by high unemployment.

It is pretty obvious that low unemployment would enhance wage growth amongst middle- and low-income workers. But the policies to create low unemployment are not as clear:

Raising inflation to lower real interest rates would not get strong support in many quarters. It would seem that you are manipulating market signals to dupe business investors to act in a fashion that may not be in their long-term best interest.
Infrastructure spending is the key to a sound recovery, but beware of raising public debt to fund anything other than productive assets that can generate a market-related return (to service the debt).
The trade deficit is a big part of any solution. We need to penalize currency manipulators like China (Japan before them) for buying US Treasurys to suppress their exchange rate and undermine US manufacturers.
Job sharing is not a long-term solution, but it does enable unemployed workers to retain skills that would otherwise be lost.

Overall, an excellent summary of what needs to be done. But it omits one vital piece of the puzzle. How do we get politicians and interest groups to act in the best interest of the country rather than their own?

July 1, 2014

Full Employment and the Path to Shared Prosperity | Dissent

Great summary of the current political gridlock by Dean Baker and Jared Bernstein:

There are many policies that can reduce inequality, but there is none as straightforward conceptually and as difficult politically as full employment. The basic point is simple: at low rates of unemployment, the demand for labor allows workers at the middle and bottom of the wage distribution to achieve gains in hourly wages, annual hours of work, and thus income.

Levels of unemployment are not the gift or curse of the gods; they are the result of conscious economic policy. The decision to tolerate high rates of unemployment is a choice. It is one that has enormous implications not just for the millions of people who are needlessly unemployed or underemployed but also for tens of millions of workers in the bottom half of the wage distribution whose bargaining power is undermined by high unemployment.

It is pretty obvious that low unemployment would enhance wage growth amongst middle- and low-income workers. But the policies to create low unemployment are not as clear:

Raising inflation to lift real interest rates would not get strong support in many quarters. It would seem that you are manipulating market signals to dupe business investors to act in a fashion that may not be in their long-term best interest.
Infrastructure spending is the key to a sound recovery, but beware of raising public debt to fund anything other than productive assets that can generate a market-related return (to service the debt).
The trade deficit is a big part of any solution. We need to penalize currency manipulators like China (Japan before them) for buying US Treasurys to suppress their exchange rate.
Job sharing is not a long-term solution, but it does enable unemployed workers to retain skills that would otherwise be lost.

March 8, 2014

In the Real World the Trade Deficit Is More Important Than the Budget Deficit | CEPR

Dean Baker writes:

….the trade deficit is a direct measure of the amount of demand that is going overseas rather than being spent here. This represents income generated in the United States that is not creating demand in the United States. By definition, this lost demand must be made up by other borrowing, either by the public sector (i.e. budget deficits) or the private sector. Currently the trade deficit is running at an annual rate of around $480 billion (@ 3.0 percent of GDP), which means that the sum of net borrowing in the public and private sector must be equal to $480 billion.

November 7, 2011

Germany must do it, not China | Credit Writedowns

In the end this is Germany’s crisis to resolve, not China’s. Germany has benefited tremendously from the euro. Nearly all of its growth in the past decade can be explained by its rising trade surplus which, given monetary policy driven almost exclusively by the needs of slow-growing and consumption-repressed Germany, came at the expense of the rest of Europe.

If the Germans want to save Europe, they must reverse their polices and start running large trade deficits even if that comes with slower growth. If not, the euro will break apart and peripheral Europe will almost certainly default on its obligations to Germany. Either way Germany loses.

via Germany must do it, not China | Credit Writedowns.