Emerging Markets

In early January, data showing a sharp fall in Asian exports -- a couple of Asian countries, led by Korea, tend to report trade data faster than anyone else -- signaled a much broader slump in global trade. The trade data for q1 is now in for most of the world, and it is (predictably) grim. China’s exports were up close to 20% y/y in q3 2008. They were down 20% y/y in q1 2008. Japan’s exports are now, stunningly, down close to 50% y/y. Germany isn’t doing much better. In February -- the last monthly data point -- exports were down by 23%, but in April German auto exports were down 48%. Turkey’s exports are down 33%. Trade contracted exceptionally sharply almost everywhere. A sudden deceleration global demand growth -- probably augmented by an inventory correction and in some case a shortfall of trade finance -- is undoubtedly the main reason for the very sudden fall in global trade. On the other hand, there is now some evidence that the contraction has ended, at least in Asia. Korea’s April exports, for example, topped its March exports. A chart showing Korea’s monthly exports and imports isn’t as scary now as it was a few months ago. Korea’s April 2009 exports are about equal to its April 2007 exports. The y/y fall in Korea’s exports is now similar to the fall in 2001 -- when the tech bust hit Korea hard. That counts as good news these days, as for a while it looked like the current fall would be far larger. And if Chinese manufacturing is truly now poised to expand again on the back of China’s stimulus -- as China’s PMI data (perhaps) suggests -- Chinese imports should start to grow again, supporting global demand. Three important caveats though are in order: 1) The Korean won has depreciated quite significantly over the past year. It started to slide a year ago. That had helped to limit the fall in Korea’s exports. Korea is clearly increasing its share of a shrinking market. The fall in Japan’s exports in March was much larger than the fall in Korea’s exports in March. 2) US demand for Korean autos (Hyundais in particular) have fallen by much less than the fall in total US demand for cars. See FT Alphaville’s useful chart. That is one big reason why Korean exports have held up better than Japanese -- and for that matter German -- exports. This no reflects at least in part the effect of the won’s weakness. It is a lot easier to offer to cover the payments of a person who loses their job if the won is at 1400 -- or 1200 -- than if the won is at 900. 3) Korea’s imports are still in the doldrums. That reflects, above all else, the huge fall in commodity prices, and thus the huge fall in Korea’s commodity import bill. But it would still be nice to see imports start to bounce off their monthly lows, as the fall in commodity prices is already reflected in the recent monthly data. The last point applies throughout Asia. Last week the Wall Street Journal ran a story highlighting how the benefits of China’s stimulus were trickling out to the world -- and to the US. Caterpillar in particular seems to be a big beneficiary, and GM also has been helped by the big jump in Chinese auto sales. Areddy and Aeffel wrote: China’s efforts to quickly pump up its economy are providing a much-needed boost for U.S. businesses as well ... A growing number of companies, from tire and excavator makers to fast-food chains, are benefiting from China’s $585 billion stimulus program Fair enough. But the article lacked one key bit of context. The last available US data (for January and February combined) indicates that US exports to China are down 24% y/y. The US data is a bit dated by now, as there are signs that China’s economy picked up in March, April and May (after what I think was an exceptionally sharp deceleration in the fourth quarter). But until there is evidence that China is importing more not less -- and evidence that China’s trade surplus is falling -- it is pretty hard to argue that China is supporting global demand. The data showing the y/y change in US exports to China - which admittedly only runs through February --isn’t exactly encouraging. Anecdotes are best when they tell a story that is grounded in the actual trade data. Reporting on turning points is hard. But it is important to note that China’s stimulus has yet to really register in either its import data -- or in data showing the world’s exports to China. Let’s hope that China’s trade data from the second quarter ends up telling a different story than the data from the first quarter.

That isn’t a question that is usually asked in the debate about the "right" size of the IMF. But it strikes me as a question worth asking. Back in 2006, US growth slowed relative to growth in the world. Private demand for US assets fell.* But the US didn’t have to "adjust" -- that is to say bring its trade deficit down to reflect the reduced availability of private financing. Why not? Emerging economies, who received most of the influx of private money not going to the US, generally used this influx to build up their reserves. A rise in financing from central banks and sovereign funds offset the fall in (net) private demand for US assets.** The US trade deficit fell a bit relative to US GDP, but not by all that much. Thanks to a generous supply of credit from the emerging world’s central banks, the party kept going long after private investors ceased to be willing to finance it. Suffice to say that when emerging economies running comparable deficits to the US encounter a comparable fall off in private financial flows, the amount of financing that gets recycled back their way by the US and EU (through institutions like the IMF) is far smaller. Between 1997 and 1999, "volatile" private capital flows (bank loans and portfolio flows, I left FDI out) swung from a $100 billion inflow to a $100 billion outflow. The net increase in IMF’s lending over this time by contrast was only around $30b -- not all that much relative to the $200 billion swing. The current crisis isn’t all that different. Between 2007 and 2009, volatile capital flows are expected to fall from a positive $250 billion to a negative $400 billion -- a swing over over $650 billion. IMF lending -- based on all existing programs -- will increase by close to $120 billion (see this chart by my colleague Paul Swartz). That is more than in the past, but not enough to offset the fall in capital flows, and certainly not enough to offset the combined impact of lower capital flows and lower commodity prices on the commodity exporting region. Scaled to world GDP, the current swing in private capital flows and the (projected) rise in official lending looks roughly similar to the swing back in 97-98. I don’t know what the right balance between financing and adjustment is. No one probably does. And it clearly varies from country to country. Some countries are in worse shape than others. But it is still striking that the emerging world did more to help the US avoid adjustment from say early 2006 to mid 2008 than the US, EU and Japan seem likely to do (through the IMF and World Bank as well as bilaterally) to help the emerging world avoid adjustment now, even with the recent expansion of the IMF.*** Call it part of the United States exorbitant privilege. So long as key emerging economies peg to the dollar and allow their reserves to rise when private demand for their financial assets rises, the US gets more protection from a sudden reversal in capital flows than other countries with large deficits. But also call it part of a broad system that has resulted in a persistent uphill flow of capital -- and thus part of a broad system that led the US to run larger external deficits over the past few years than really were healthy. * US investors started buying more non-American long-term assets while (private) foreign investors lost interest in US assets. The fall in private demand though wasn’t immediately apparent because a lot of official flows initially registered as private flows through the UK and other financial centers. ** $100 billion in "private" outflows from China in 2006 lowered the global total. Those private outflows though were clearly the product of an effort to hand some of China’s reserves over to the state banks to manage. They weren’t really private. *** It also interesting that the $200 billion or so in financing Russia got from the sale of its reserves far exceeds the IMF’s total commitments to date; that helps put the IMF’s actions in context.

One issue to watch over the next few days, as the world’s finance ministers gather for the IMF’s spring meetings: whether or not the G-20 (and other) countries carry through on their pledge to expand the resources available to the IMF. The IMF cannot supply credit to a host of troubled emerging markets unless it gets credit (via its supplementary credit line, or a bond issue sold to key central banks with excess reserves) from a bunch of countries in a (somewhat) stronger financial position. But also give the IMF credit for producing analysis that has become an essential guide to the current crisis. Like Dr. Krugman, I am eagerly awaiting the release of first few chapters of the WEO tomorrow. That is something that I couldn’t have credibly said all that often in the past. The detailed WEO will provide a baseline, among other things, for assessing whether the fall in the world’s macroeconomic imbalances in the first quarter can be expected to persist for this year, and for the next. The IMF’s Global Financial Stability Report – released today – already provides a baseline for assessing the scale of the losses that the last credit cycle will generate (gulp, over $4 trillion, with $2.8 trillion from the US – two times as much as the IMF forecast in October) and thus, in broad terms, the scale of the new capital the financial sector needs. This crisis challenged the IMF. A truly global crisis calls out for a global response, underpinned by high-quality global analysis. A few years back, the IMF’s surveillance wasn’t perhaps as focused on the underlying risks of an unbalanced and highly leveraged world as it should have been. Just look at the IMF’s 2007 economic health check for the US , which declared – a minus a caveat or two - that the core of the US financial sector was well capitalized and “relatively protected from credit risk” (see paragraph 5, on p 10 of the staff report/ and paragraph 5 of the PIN/ ). Oops. Of course, the IMF’s assessment of the US financial sector echoed the conventional wisdom of the time. And, in other areas, the IMF can credibly argue that it highlighted risks that others wanted to ignore. It, for example, consistently called attention to the build-up of balance sheet risk in emerging Europe. Suffice to say that the IMF didn’t risk making the same mistake in its current Global Financial Stability Report. Chapter 1 of the Global Financial Stability Report makes for sobering reading. The IMF paints a picture of a global economy where neither large financial institutions in the world’s economic and financial core nor those emerging market governments with large external financing needs can count on financing themselves in private markets. Both sets of borrowers, in effect, now rely on the support of official institutions, whether the IMF, the the world’s large central banks or taxpayers. The financial sector relies on official support for the money it can no longer raise in the “wholesale” funding market*, and emerging markets to offset the withdrawal of cross-border bank lending. On p. 39, the IMF writes: “private bank funding markets are mostly closed – banks rely on central banks and the government (for guaranteed unsecured financing)” Even relatively healthy large the banks – the kind that are assumed to be too systemically important to fail – still cannot consistently obtain long-term financing without an explicit government guarantee. Call it the Fannie and Freddie problem: right now, a still-nervous market isn’t willing to accept implicit guarantees. Table 1.7 shows the scale of European (eurozone and UK) banks reliance on wholesale financing. It is rather extraordinary. I would though be interested if Alea thinks the IMF’s analysis overstates European banks wholesale funding needs. And on p. 58 (annex 2, figure 1.45): The IMF’s model for emerging market lending that the world’s big banks, which the emerging world about 2.5% of the emerging world’s GDP, will pull twice that much credit from the emerging world over the next few years. “the model’s projection … implies a sudden stop, with substantial net outflows of other investment [bank lending, in balance of payments-ese] that average 5% of GDP over the next few years. Outflows of this magnitude were registered in the late 1990s by several southeast Asian countries in the 1990s, and in the early 1980s by Latin American countries.” That may be a bit too pessimistic, but it does illustrate the overarching risk. The IMF, in effect, says that the there is a real risk that the world of the next few years will be marked by a long hard slog of deleveraging, not a quick rebound of confidence. The good news – such as it is – comes on p. 34, in the widely cited IMF’s table 1.4. It shows the IMF’s estimates of the size of the financial sector’s losses. The IMF estimates that US banks need about $300 billion to get back to their pre-crisis leverage levels, and $500 billion to get back to their leverage levels of the 1990s. That is (roughly) 2-3% of US GDP. I fully understand the political difficulties of getting this money – and putting equity into the banks it in a way that is perceived as fair by both the taxpayer and the banks’ employees. But this – as Dr. Bernanke has noted -- isn’t a sum that is beyond the United States’ fiscal capacity. The UK, frankly, has it far worse. Its banks are estimated to need about ½ as much capital as US banks, and the UK’s economy isn’t close to half the size of the US economy. Other tidbits that jumped out at me (underlying data can be found here): -- The IMF forecasts emerging markets will see outflows of 2% of their GDP from the banking sector (“other investment”) and 1% of GDP from the sale of their securities by investors in advanced economies (“portfolio investment”). On the banking side, the outflows seem a bit smaller than what the IMF’s model would blindly forecast based on its input variables. (p. 7) -- The IMF forecasts that the UAE will run almost as large a current account deficit as Pakistan (both are in the 5-6% of GDP range). Given its maturing debts and this financing need, the Emirates isn’t – based on this analysis – cash rich, though ADIA still has a large stock of assets. (p. 10/ table 1.1) -- The IMF forecasts a far bigger contraction in private credit growth to emerging economies than in the 97/98 crisis. That is probably too pessimistic – China will make sure of that. But most emerging economies are in a quite different position than China, which pushed up its external surplus by holding loan growth below deposit growth from 04 on (p. 16/ figure 1.15) -- Figure 1.20 (on p. 23) shows expected loan losses in the US relative to the history of the past 30 years – it isn’t a pretty picture. Figure 1.30 (p. 30) shows bank loan charge-offs over a very long time period. Forecasts charges (i.e. losses) aren’t expected to exceed those in the 1930s, but they are very large. Look at the figure. A core function of the financial system, presumably, is to lend money to those who can pay it back. If the IMF’s analysis is right, the US financial sector didn’t too a particularly good job of this – And presumably scaling bad loans across this lending cycle to financial sector pay across this lending cycle wouldn’t improve the picture. After reading the IMF’s financial stability report, I find it hard to argue with Dr. Wolf, who writes: ‘Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history. To take an extreme example, Ireland is -- per the IMF (Table 1.10) planning to try to issue something like $640 billion in guaranteed debt. And Ireland is a rather small country. * wholesale funding is, in very broad, terms bank financing that doesn’t come from small insured depositors.

Many Eastern European countries have a strong need for external financing. Negative current accounts and dangerously high levels of short-term debt are raising fears of financial instability. EU leaders on March 1st rejected calls for a $229 billion rescue fund for struggling economies in the east. Instead of a single plan for the region, the EU will be taking a case-by-case approach. The following articles discuss the problems facing Eastern Europe. Economist: The European Union-Ailing in the East Economist: Ex-communist Economies Barber: EU To Aid Countries in Eastern Europe Wagstyl: Variable Vulnerability Forelle: EU Rejects a Rescue of Faltering East Europe

CFR Senior Fellow Laurie Garrett says the recent Davos economic forum failed to provide any blue print for reconciling the financial crisis and development aid needs. She predicts donor nations will "face tough sells, trying to convince their voters that it is vital to spend money feeding starving masses abroad."

Macroman reports that there is a bit of optimism in the air about China right now. Loan growth was strong in January. Steel prices have picked up a bit. The latest Chinese purchasing managers survey wasn’t as bad as the last one. The fall in the pace of contraction in activity has generated hope that China’s economy will rebound later in the year. China’s stimulus will help, as will the fact that China’s state banks are liquid and have clear instructions to lend ... Everyone looks at China through their own lens. My lens is the trade data. And there I still don’t find much basis for optimism. China’s January trade data isn’t out, but Korea’s data is -- and it was awful. The sheer scale of the fall in Korean and Taiwanese exports shows up most cleanly if monthly exports are plotted over time. A plot of the y/y change confirms that the current slowdown is sharper than past slowdowns, and given the strong growth in exports over the past several years, a bigger percentage change interacts with a bigger base to produce a far bigger absolute fall.* I share Paul Krugman’s and Kevin Drum’s assessment of the "Buy American" provisions in the stimulus package: the impulse behind these provisions is understandable, but their likely costs exceed their likely benefits.** But I do wish that there was a bit more recognition on the part of those bankers highlighting the risks poised by protectionism of the scale of the collapse in trade that has ensued from the collapse of the financial sector. Not all risks to the flow of goods across borders emanate from Washington DC. Back to China. Korea’s exports to China have been falling faster than Korea’s overall exports. The same is true for Taiwan. There are two potential explanations for these sharp falls. -- a sharp fall in demand from the US and Europe, which is percolating back through Asia’s supply chain and will soon hit China’s exports. -- a sharp fall in demand inside China. Neither strike me as positive for China. Actually there is a third explanation. The contraction in trade finance and a one-off inventory correction (the buildup of inventories in the US -- think all the cars piled up near US ports -- in q4 triggered a fall in production globally) have pushed Asia’s exports down more sharply than is warranted by the fall in underlying demand. As trade finance is restored and inventories are worked off, intra-Asian and global trade will pick up again. I certainly hope so. But right now the trade data suggests an ongoing contraction in activity in Asia. That in some sense is the risk Asia incurred by relying so heavily on exports to support their growth. The production of tradeable goods has always been cyclical. Durables in particular. Car purchases can be deferred in a downturn. In a sense, export-based Asian economies made the same bet as the European and American financial sector: both were betting on low levels of macroeconomic and financial volatility in the US and Europe. Asia isn’t the only source of concern either. European trade is also contracting, though not quite as rapidly as intra-Asian trade. The collapse of cross-border financial intermediation likely means that oil-importing Eastern Europe won’t be able to continue to get the loans it needs to sustain large current account deficits. Oil-exporting Russia clearly has to cut back as well. That means less demand for German -- and other -- exports. The net result: there is plenty of spare capacity globally. Look at the graphs accompanying Martin Wolf’s commentary on Davos. They suggest, at least to me, that deflation from insufficient demand remains the key risk facing the global economy ... * Thanks to Paul Swartz for help with the graphs. Do check out his updated graphs comparing how the currency recession compares to other post-World War II downturns. Korean and Taiwanese imports have fallen by roughly as much as exports. I am more surprised though by the scale of the fall in exports. I would expect a fall in commodity prices to lower Korea’s imports and to increase its trade surplus. The fact that the huge fall in imports hasn’t pushed the surplus up is striking. ** There is a real issue though, as the cost (more debt) of a stimulus are born nationally while the benefits are shared globally. But the best response remains a global stimulus, where the US stimulus creates demand for other countries’ good and other countries’ stimulus creates demand for US goods. And -- contrary to Martin Hutchinson -- it really doesn’t matter if the source of demand is "private" consumption or "public" consumption. The key is generating some kind of demand to support activity. If that comes from public spending, find. And if Asian governments prefer spur private consumption, there are a host of ways to do so ... Bailouts of global banks pose some of the same issues, as the costs of a bailout are born by national taxpayers while some of the benefits are shared globally. A world where national governments (read national taxpayers) are the key pillar supporting demand and banks is likely to be a bit different than a world dominated by private spending and (truely) private banks.

The US clearly failed to recognize the risks associated with highly leveraged households and an over-leverage and under-capitalized financial sector. The resulting implosion has reverberated globally. But I don’t quite see the basis for arguing that the US fiscal deficit is siphoning funds from the rest of the world. It may in the future. But right now it isn’t. The amount the US borrows from the world is a function of the trade deficit (really the current account deficit, but the trade deficit is a good proxy), not the budget deficit. And the trade deficit is coming down. Calculated Risk estimates that the January deficit could be as low as $30 billion, or only about 1/2 its peak level. Thank the fall in oil prices. Put simply, the US is borrowing a lot less from the rest of the world now than a year ago, two years ago or three years ago. Moreover, the US doesn’t magically attract funds from the rest of the world. In order to pull in savings from the rest of the world, the US has to offer a higher (risk-adjusted) return than other borrowers do. The ten year Treasury has sold off (see Jansen). It no longer yields 2%, but it still yields less than 3%. And that isn’t exactly a high rate. The way the US pulls in funds from the rest of the world is by offering a higher interest rate than the rest of the world. That ends up driving up interest rates globally and forcing other countries to pay more to borrow. Today though US rates are well below there levels a year ago. If anything that should create incentives for US investors to send funds abroad -- not incentives to pull in funds from the rest of the world. And well, I don’t think anyone can argue that high short-term rates in the US are sucking savings out of the world. If anything, low policy rates in the US should make it easier for other countries to raise funds. It isn’t hard to offer a yield pickup over the US right now. Last fall when the Fed was cutting rates and other countries weren’t, private money was flowing out of the US ... This isn’t to say that the problems emerging economies now face trying to raise funds originated in the emerging world. They didn’t. Not really. They are suffering from the collapse of the US -- and European -- financial sector. Hedge funds are pulling back. And more importantly, capital constrained banks are pulling back. That -- not the fiscal deficit -- is what is pulling funds out of the emerging world. Emerging economies in that sense are no different than any other borrower facing difficulties getting a bank loan. The fact that the financial sector now depends on a government backstop may have prompted the banks to pull back more from foreign markets than their home markets, though they are clearly doing both. Deglobalization -- particularly financial deglobalization -- isn’t going to be pretty. But a few emerging economies are also suffering from self-inflicted wounds ... Not the least Russia. Russia exports a lot of oil. But for a long time it tried to keep the ruble pegged (more or less) to a euro-dollar basket even as oil soared -- and even as private capital poured into Russia. Russia though didn’t sterilize these inflows as effectively as China. The resulting rise in domestic inflation led Russia’s real exchange rate to appreciate quite significantly. Now, obviously, there is pressure for the ruble to depreciate in real terms. That could happen through deflation. Latvia has chosen this course. But investors -- and Russians -- believe that Russia will let the ruble depreciate in nominal terms to bring about the needed real depreciation. And until that process is complete, there isn’t much incentive to old rubles. See Slater and White in today’s Wall Street Journal. They quote Natalya Orlova, chief economist at Alfa Bank in Moscow: "All the rubles that are out there have been turned into dollars. To get out of this spiral where everyone expects a devaluation will be very difficult." Capital isn’t flowing out of Russia because the US fiscal deficit deficit has pushed up US Treasury interest rates to levels no other country can match-- or because Russia cannot match the high rates on offer on dollar bank deposits. It is flowing out of Russia because a lot of people believe the ruble is still overvalued. It actually is fairly common for oil exporters to experience a real appreciation through inflation and a real depreciation through a sharp fall in the nominal exchange rate. The mechanism for real exchange rate adjustment isn’t always symmetric. I though would argue though that the oil-exporters generally would be better off letting their currencies rise along with oil -- and also fall along with oil. The right exchange rate for Russia is -- I suspect -- tied to the price of its key export. But at this stage, though, this is a rather academic point. The key issue is just how many more reserves Russia is willing to spend to prevent the ruble from falling further ... p.s. On a more technical basis, the investors who buy US treasuries aren’t typically the same investors who buy emerging market debt. They rather are the kind of investors who might otherwise buy Agency paper or similar close substitutes for Treasuries. The money market funds now buying Treasuries were never buyers of emerging market debt. Russian debt -- particularly ruble debt -- is held by investors with a higher appetite for risk. That problems Russia faces right now consequently have a lot more to do with the broader deleveraging process than the scale of Treasury issuance. Yes, there are knock-on effects if the US sucks up a lot of funding with a large fiscal deficit. But those effects are indirect and generally operate through a rise in US interest rates. Conversely, Russia would certainly benefit if a fiscal stimulus pushed up US demand and that in turn pushed up oil prices ...

James Saft of Reuters worries that the crisis will lead to a shift away from the "Davos consensus," especially as the market’s power had pulled so many out of poverty. "the stuff underlying the Davos consensus really was pretty good at doing lots of things, not least raising living standards in huge swathes of the developing world. States aren’t traditionally all that great at allocating resources either" Reasonable point. But the narrative of the past six years isn’t really one defined solely by the retreat of the state and a greater role for markets in allocating resources in the developing world. In both China and many fast-growing (until recently) oil-exporters, the state played an active role in guiding investment decisions. It thus was helping to determine how resources were allocated across sectors. -- Most Chinese investment, as Nick Lardy and Morris Goldstein pointed out a while ago, is financed domestically. And a lot of that investment is financed by the retained earnings of state firms or by loans from state banks. Perhaps all of these investments were done on a purely commercial basis, but there was certainly scope for the state to guide the allocation of resources. -- Most oil exporters have powerful national oil companies that control the oil revenue stream. And a lot of "private" investment in Gulf came from banks and firms that were either owned by the state or by the "palace." A host of firms borrowed not on the basis of the strength of their own balance sheet but on the perception that they were too close to the state to fail. Dubai is often presented as a model of free-wheeling capitalism. But Dubai, inc remains closely tied to the palace. Simeon Kerr and Roula Kalaf of the FT: "Dubai’s sprawling business empire spans government institutions and private companies owned directly by Sheikh Mohammed but acting as quasi-government bodies. The ruler has instituted a culture of competition among state-backed companies and insisted they run themselves as private sector entities. In their quest to satisfy his ambitions, the business groups have come to rely heavily on debt – leveraging myriad commercial ventures, from domestic property developments to international acquisitions. Along the way, Dubai’s finances have become complicated and the line between ruler and government assets blurred. It turns out that state backed companies weren’t borrowing as private sector entities -- or at least no one who was lending them money thought so. They were able to borrow so much largely because of their state backing. And now, given Dubai, Inc’s cash flow troubles, Dubai, Inc may soon morph into Abu Dhabi, Inc. -- Exchange rate policies can also influence the allocation of resources across sectors. China’s de facto dollar peg is an obvious example. Pegging to the dollar as the dollar fell from 2002 to early 2005 produced a large real depreciation in the RMB. The RMB then rose v the dollar, but never by enough to fully offset the dollar’s fall. The BIS estimates that China’s real exchange rate was weaker at the end of 2007 than at the end of 2000 -- even though China’s exports grew by a factor of five during this period. The nominal and real depreciation of the RMB encouraged foreign firms to set up shop in China and encouraged domestic investment in the export sector; it is hard for me to believe that as much would have been invested in China’s export sector if China had had a different exchange rate regime. China’s policies also influenced -- in all probability -- the global allocation of resources. Before the recent crisis, remember, private capital wanted to finance current account deficits in the emerging world, not the current account deficit associated with the US household sector’s borrowing need. By holding US interest rates down and the dollar up, China’s policies discouraged investment in tradables production in the US while encouraging investment in the interest-rate sensitive sectors that weren’t competing with Chinese production. This isn’t too say that the US didn’t already have a slew of policies in place to encourage investment in housing. It did -- from the Agencies to ability to deduct mortgage interest from tax payments. But the surge in demand for US bonds from the world’s central banks reinforced those policies. Larry Lindsey argued -- I think correctly -- that China’s policy of spending huge sums - to keep its exchange rate from rising, China often had to spend 15% or so of its GDP buying foreign assets -- to avoid currency appreciation didn’t affect overall levels of output or employment in the US, but it certainly affected the composition of output and employment. More money was allocated to home construction (for a time) and less to investment in the production of goods for export than otherwise would have been the case. My point is simple: A lot of global growth during the boom came in countries where the government owned or influenced the domestic banking sector and thus influenced the domestic allocation of credit. And policies that kept exchange rates lower than they otherwise would also indirectly encouraged private investment in those countries export sectors as well as discouraging investment in the export sectors of other countries. Governments were playing a significant role in the allocation of capital even before there was any talk of nationalizing the financial sector of key G-7 countries. Those who attribute the growth of the past several years solely to the market miss the large role the state played in many of the world’s fast growing economies. Conversely, those who attribute all the excesses of the past few years to the market miss the role that governments played in financing many of those excesses ...

During the good times, both exports and investment boomed. Indeed, the fact that China ran a large current account surplus even as Chinese domestic investment soared -- something only possible because of a large increase in China’s national savings rate -- was one of the global economy’s core puzzles. Investment booms generally lead to current account deficits (setting aside investment booms financed by spare petrodollars) not large surpluses. The risk always was that exports and investment might turn down at the same time. And, alas, that indeed is what seems to be happening. The Economists’ analysis this week was spot on: many of Asia’s tiger economies seem to have been hit harder than their spendthrift Western counterparts. In the fourth quarter of 2008, GDP probably fell by an average annualised rate of around 15% in Hong Kong, Singapore, South Korea and Taiwan; their exports slumped more than 50% at an annualised rate ... . In the fourth quarter of 2008, real GDP fell by an annualised rate of 21% in South Korea and 17% in Singapore, leaving output in both countries 3-4% lower than a year earlier. Singapore’s government has admitted the economy may contract by as much as 5% this year, its deepest recession since independence in 1965. In comparison, China’s growth of 6.8% in the year to the fourth quarter sounds robust, but seasonally adjusted estimates suggest output stagnated during the last three months. Asia’s richer giant, Japan, has yet to report its GDP figures, but exports fell by 35% in the 12 months to December. In the same period, Taiwan’s dropped by 42% and industrial production was down by a stunning 32%, worse than the biggest annual fall in America during the Depression. Note the scale of the fall in Taiwanese production. There is a big difference between "worse since the Depression" and "worse than the Depression." Hopefully the fall in Taiwanese production reflects a one-off inventory adjustment in the global electronics supply chain. Japanese industrial production is also down significantly. Asia’s slowdown isn’t just a magnified reflection of the fall in US (and European) consumption. The Economist notes in its leader: "Most of the slowdown in regional economic growth so far stems not from a fall in net exports but from weaker domestic demand." More details are provided in the longer analysis piece: Asia’s export-driven economies had benefited more than any other region from America’s consumer boom, so its manufacturers were bound to be hit hard by the sudden downward lurch .... Shocking as the export figures are, they are not entirely to blame for Asia’s woes. A closer look at the numbers reveals that in most countries imports have fallen by even more than exports, and that weaker domestic demand explains a larger part of the slump. In China, for example, weaker domestic spending—mainly the result of a collapse in housing construction—accounted for more than half of the country’s slowdown in 2008. In South Korea, net exports actually made a positive contribution to GDP growth in the fourth quarter, while consumer spending and fixed investment fell at annualised rates of 18% and 31% respectively. ... Domestic spending has collapsed elsewhere. Over the past 12 months, retail sales have fallen by 11% in Taiwan, 6% in Singapore and 3% in Hong Kong. ... A recent report by Frederic Neumann and Robert Prior-Wandesforde, two economists at HSBC, a large bank, argues that Asia is suffering two recessions: a domestic one as well as an external one. Domestic demand had been expected to cushion the blow of weaker exports, but instead it was hit by two forces. First, the surge in food and energy prices in the first half of 2008 squeezed companies’ profits and consumers’ purchasing power. Food and energy account for a larger portion of household budgets in Asia than in most other regions. Second, in several countries, including China, South Korea and Taiwan, tighter monetary policy intended to curb inflation choked domestic spending further. With hindsight, it appears that China’s credit restrictions to cool its property sector worked rather too well. The two recessions reinforced one another. Part of the slump in domestic spending is attributable to falling exports, which force firms to cut investment and lay off workers. The fact that China’s imports are falling more than its exports may not be an accident; China’s domestic economy has slowed alongside its export sector. That is a problem for China -- but also the world. China would find it far easier to transition away from export-led growth if investment was soaring even as trade contracted. That is, incidentally, what happened in the US in the late 1990s: a boom in investment (think .coms) offset the impact of the Asian crisis on US trade. And US demand, in turn, helped pull Asia out of its crisis. The Economist argues that Asia cannot continue to rely on foreign demand to pull Asian economies out of their cyclical downturn -- or as a future source of growth. Asian governments have more than this year’s growth rate to worry about. Beyond the immediate crisis, where will growth come from? America’s consumer boom and widening trade deficit, which powered much of Asia’s growth over the past decade, has come to an end. America’s return to thrift is unlikely to prove a cyclical blip. For years to come, Americans will have to save more and import less. Asia’s export-led growth therefore seems to have reached its limits. It needs a new engine of growth: in future it must rely more on domestic demand, especially consumption. In recent years, it has been doing the opposite: consumer spending has fallen as a share of GDP, while the share of exports and investment has climbed (see chart 4). Two decades ago, consumer spending accounted for 58% of Asia’s GDP. By 2007 it had fallen to 47%. Consumer spending in China is just 36% of GDP, half the American share. The fall in China’s ratio of consumer spending to GDP largely reflects a fall in wage income to GDP, not a rise in household savings. The Economist notes, correctly: "The popular explanation [for the fall in consumption] is that it is all because frugal households have been saving a bigger slice of their income in response to uncertainty over pensions and social welfare—uncertainty that will presumably increase in a recession. But this doesn’t quite fit the facts. In many countries, notably South Korea and Taiwan, household savings have fallen relative to income in the past decade; in China they have been broadly flat. (The rise in China’s savings rate comes from firms and the government, not households.) The core goal of Chinese policy over the next few years, it seems to me, should be to raise the ratio of consumer spending to GDP. China’s exports aren’t going to increase by factor of five over the next eight years; mechanically, exports simply can not provide the boost they did in the past. And investment is already very very high relative to GDP. That leaves only one potential engine that could propel China’s future growth ... UPDATE: Korea’s January trade data was terrible. Exports to China are down more than total exports. And Korea is now running a trade deficit despite the huge fall in commodity prices because exports have fallen more. Japan is in a similar position. That suggests a huge fall in the global current account surplus, as the fall in the oil exporters surplus doesn’t seem to be offset by a rise in Asia’s surplus.

Only a few months ago it was common to argue that growth in the emerging world would prevent a global recession. That forecast looks increasingly wide of the mark. The slowdown in the emerging world now looks to be as severe – and potentially more severe – than the slowdown in the advanced economies. Morgan Stanley’s currency team recently observed that "Brazil’s growth collapsed in 4Q08, with several activity indicators displaying the worst decline on record." Earlier this year Brazil was growing strongly on the back of both strong domestic demand and strong global demand for its commodities. The domestic growth dynamic (and the improved state of the balance sheet of Brazil’s government) made me think it might be able to ride out this crisis relatively well. Guess not. Russia is in even worse shape. Output is poised to fall sharply. Danske Bank expects a 3% fall. That might be optimistic. Moving from a budget that balances at $70 oil to a budget based on $41 a barrel isn’t fun even if Russia uses its fiscal reserve to adjust gradually. Eastern European economies that relied on large capital inflows rather than high commodity prices to support their growth aren’t doing any better. The Gulf is in better shape than Russia, but that isn’t saying all that much. $40 a barrel oil requires the Gulf to dip into its foreign assets, but most countries still have plenty of spare cash (though not as much as before). Still, all of the Gulf is slowing. And the most exuberant bits of the Gulf – Dubai in particular – are in real trouble. Most of the Gulf’s sovereign funds under-estimated their countries need for emergency liquidity. They aren’t quite in the same position as Dubai’s Istithmar (looking to sell Barneys for cash as demand for luxury goods falls), but they presumably do wish that they had more liquid assets -- and more assets that weren’t correlated with oil. The commodity-importing BRICs aren’t doing much better. India is slowing. And China is really slowing. Stephen Green of Standard Chartered has constructed an indicator of Chinese economic activity that isn’t based on the government’s reported GDP data. It suggests a far bigger fall in Chinese output than in 1998.* Chinese output shrank in the fourth quarter. The first quarter isn’t going to be any better. China isn’t alone. The fall in Korea’s output in the fourth quarter was quite large. Even larger than the fall in output in UK, or Japan. Yuka Hayashi of the Wall Street Journal: South Korea’s economy last quarter shrank 5.6% from the July-September period, or an annualized rate of 20.8%, according to J.P. Morgan, the sharpest contraction since the Asian financial crisis a decade ago. Singapore and Taiwan are also contracting sharply. Singapore’s economy contracted an annualized rate of 12.5% in q4, and the huge fall in Taiwan’s exports cannot be good for its economic performance. Japan isn’t an emerging economy, but it too saw a sharp fall in output. It isn’t a stretch to think that Asian output could fall more in 2009 than in the 1997-98 Asian crisis. Emerging economies who thought that they had protected themselves from sudden swings in capital flows by maintaining large reserves and running large external surpluses are discovering that their efforts to reduce their exposure to volatile global capital flows added to their exposure to a global slump in trade. Emerging economies were growing faster than the mature economies prior to the crisis. But at this stage I wouldn’t rule out the possibility of an outright contraction in the output of the emerging world in 2009. And that could imply that a crisis in the US and Europe could end up producing a bigger absolute swing in activity in the emerging world than in the world’s mature economies … * This graph was reproduced with permission from Stephen Green.

I’ll be unusually brief. I have been working through the latest data on China -- and, well, it is hard to top Calculated Risk. The fall in the US trade deficit today was easy to anticipate. The average price of imported oil was sure to fall from $92 in October. It came down to $67 a barrel in November. The petrol deficit fell by about $13 billion. That wasn’t all though. The non-petrol goods deficit also fell by about $4 billion. Y/y non-petrol goods imports were down 9.3% (they were down about 1% in October); y/y non petrol goods exports were down 4.4% in November. They were up 2.4% in November. So long as non-petrol imports fall faster than non-petrol exports, the US deficit will shrink. This shows up in clearly in a plot -- prepared by Arpana Pandey -- of real goods imports and exports. In November the down turn in imports was sharper than the downturn in exports. There isn’t anything good in this graph other than the fall in the trade deficit. Falls in exports and imports signal contracting global activity. And I am not even sure that the improvement in the trade balance will continue, as I suspect the combination of a stronger dollar and a broadening global slowdown will eventually have a major impact on exports -- and the US fiscal stimulus will bleed into imports. But the US led the world down and for now, US imports are falling faster than US exports ...

The experience of the 1997-98 East Asian crisis encouraged many developing countries to accumulate vast sums of foreign exchange reserves in order to self-insure against future crises. As our chart indicates, as of the end of November, emerging market countries were burning through these reserves. This crisis will put to test previous thoughts about necessary reserve levels and the efficacy of self-insurance. Economist: Shrinking Cushion Economist: Russia’s Economy-The Flight from the Rouble Jung-a: S. Korea Reserves Fall as Won Weakens Subramanian: Self-insurance-The Debate India Must Have Mallaby: Supersize the IMF

My title is a play on the New York Times’ online headline: "As Trade Slows, China Rethinks its Growth Strategy." The print version of the Times carries a headline that more accurately reflects the content of Keith Bradsher’s story : "Juggernaut in Exports is Withering in China." Chinese exports were doing reasonably well in October but dipped in November and -- if Korea’s December trade data offers any guide -- will fall even more in December. Industrial production is heading down too. Bradsher’s story documents the depth of the slowdown but doesn’t offer much evidence that China is "rethinking" its growth strategy. Bradsher reports: "In the last two weeks, Chinese officials have announced a series of measures to help exporters. State banks are being directed to lend more to them, particularly to small and medium-size exporters. Government research funds are being set up. The head of the government of Hong Kong, Donald Tsang, plans to seek legislative approval by late January for the government to guarantee banks’ issuance of $12.9 billion worth of letters of credit for exports. Particularly noteworthy have been the Chinese government’s steps to help labor-intensive sectors like garment production, one of the industries China has been trying to move away from in an effort to climb the ladder of economic development with more skilled work that pays higher wages. But now China has become reluctant to yield the bottom rungs of the ladder to countries with even lower wages, like Vietnam, Indonesia and Bangladesh. China has been restoring export tax rebates for its textile sector, for instance, which it had been phasing out. Municipal governments have also stopped raising the minimum wage, which doubled over the last two years in some cities, peaking at $146 a month in Shenzhen. “China will resort to tariff and trade policies to facilitate export of labor-intensive and core technology-supported industries,” Li Yizhong, the minister of industry and information technology, said at a conference on Dec. 19. " The global slump seems to have prompted China to cling to its existing export-led growth strategy. China seems to be rethinking is its previous willingness to move out of low-end labor-intensive exports as higher-end export sectors expand. With jobs scarce, that no longer seems like a great idea. China also seems to be rethinking its exchange rate policy. Here too it seems to going back to the past. Over the past several months the RMB has been effectively repegged to the dollar -- going up when the dollar went up (October) and going down when the dollar went down (December). Neither policy shift constitute a real change; both reinforce the old model of trying to spur growth by subsidizing exports. But the global environment is changing in ways that will make it harder for China to avoid a sharp downturn in its exports no matter what China does. And that isn’t just because China’s efforts to subsidize its exports and limit the RMB’s appreciation against the dollar may attract the ire of the US. Bradsher reports that Indonesia is keen to find ways to limit its imports from China that do not formally violate its WTO commitments. In Indonesia, the third most populous country in Asia after China and India, the government is already acting to limit imports of garments, electronics, shoes, toys and food — five large categories in which Indonesian producers are struggling to compete with China. Starting in the new year, importers of these products will have to be registered with the government, use only five designated ports for their shipments, arrange for a detailed inspection of goods before they are loaded on a ship or plane bound for Indonesia and then have every single container exhaustively inspected on arrival by Indonesia’s notoriously slow customs bureaucracy. The plan, intended to comply with W.T.O. rules, was adopted after heavy lobbying by Indonesian manufacturers and labor unions. h/t Rybinski The jobs argument cuts both ways. Indonesia wants jobs for its rural migrants too. China’s export sector hasn’t experienced a sharp cyclical downturn in a long time. In 2001 global trade did contract. But that contraction didn’t hit China all that hard. It came at a time when the electronics industry was migrating to China, allowing China to increase its share of a shrinking global market. Year-over-year export growth slowed from 25% at the peak of the .com boom in 2000 to 5% -- but it didn’t turn negative. In dollar terms, the y/y increase in a rolling 12m sum of China’s exports went from $50b to $15-20b. But y/y exports never fell in dollar terms.* But China now is a much much bigger share of global trade. China’s 2008 exports -- in dollar terms -- will be more than five times large than its 2000 exports. That means that China is now far more exposed to the global economic cycle than it was. And this cycle looks brutal. Korea is reporting its biggest drop in industrial production in twenty-one years. That is the kind of data point that gets my attention. I was a bit surprised to hear that the current fall is sharper than the fall that accompanied Korea’s own crisis in 97/98. The natural instinct of China’s policy makers is to do what they can to support employment in China’s export sector. But there are limits to how much China can do to offset the global fall in demand. And the more the world’s biggest surplus country does to support its exports, the more frustrated the world’s deficit countries are likely to become ... Pettis is right. If the deficit countries are the ones most willing to use macroeconomic policy to support demand and the surplus counties are among the most reluctant to run expansionary macroeconomic policies (Germany) or among the most inclined to subsidize their exports (China), the likely result is a widening deficit (meaning non-oil deficit) in the deficit countries -- i.e. bigger imbalances among the oil-importing economies-- even as activity in all economies slows. That adds to the risk of future trade conflict. Signs of future trouble aren’t hard to find even now. *1998 and early 1999 was a bit worse. Y/y export growth turned negative. But exports weren’t quite as large a share of China’s economy then -- and perhaps as importantly, China wasn’t going off a long boom where exports only went up. Volatility was far more expected then.