International Economic Policy

   

   

I am planning to take the next few weeks off—no blogging. That at least is the plan, barring a major financial surprise. It thus seems a natural time to look back at the topics I have covered in the first seven months of the year. And maybe this back catalogue can serve as at least a partial substitute for new content? The bulk of my recent output has focused on China. The coming trade war and all. I put a lot of work into the links in my post on the back story to the trade war. There is also a lot of material on bond market dynamics buried inside my post on China’s options for responding asymmetrically to an escalation in the scale of Trump’s tariffs. The argument that China has more to gain from letting the yuan depreciate than by selling off its Treasury portfolio has held up well so far. Another focus has been the technical details of China’s currency management, and shifts in the pattern of capital inflows to and from China. I think it is significant that financial flows into China were fairly balanced heading into the trade war—with China able to add to its reserves at the margin even while funding Belt and Road related outflows. That though may change in the third quarter (pro-tip: the actual balance of payments numbers for q3 won’t be out until December; watch the banking data for higher frequency clues). Trump’s multi-front trade war has not been limited to China. I don’t see the argument for pulling out of NAFTA even on Trumpian terms; trade within North America is far more balanced than global trade. But, well, there is the inconvenient fact that, thanks to China’s unloved stimulus, the biggest aggregate trade imbalances these days are found in America’s Asian allies and in Europe. China’s domestic imbalances have, for now, limited its contribution to global payments imbalances. I still think the policies needed to allow China to pull back on its stimulus without returning to a large surplus don’t get enough attention (they sort of got relegated to the back pages in the latest IMF article IV). And Korea, Taiwan, Sweden, Switzerland, and the Eurozone (both its surplus countries and in aggregate) really could benefit from a somewhat looser fiscal policies. The gap between the United States’ fiscal stance (too loose) and the fiscal stance of most surplus countries (too tight) is currently the number one underlying cause of currency misalignments and trade imbalances. I ended up writing more about emerging economies than I expected—the ability of the Turkish banking system to transform dollar funding into lira lending is fascinating, and the persistence of the financing that allows Turkey to sustain ongoing deficits remains a mystery. I should have been paying more attention to Argentina’s current account and external debt dynamics last year—its current account deficit was rising even before this year’s bad harvest, putting its external debt on a potentially explosive path. Its need to turn to the IMF shouldn’t have been a surprise.[1] The IMF is doing a better job assessing most countries’ balance of payments positions these days—big surpluses are getting a bit more attention alongside big deficits, and I like many of the methodological refinements that have been made to the Fund’s methodology for assessing external balances. But the IMF continues to be let down by its (newish) reserve metric. It missed Argentina’s vulnerability, for example, and overstates Vietnam’s need for reserves. I worry that many analysts are using it uncritically: China in no way needs a buffer of $3 trillion given its limited external debts.[2] I had fun taking a technique usually applied to emerging economies—charting cumulative flows to estimate stocks—and applying it to capital flows to the United States over the last thirty years. It turns out to provide a useful window into the net international investment position data—net FDI flows into the U.S. have been flat, so it shouldn’t really be a surprise that the U.S. doesn’t have a large positive net FDI position anymore. It will be interesting to see if rising rates start to have a material impact on the size of the United States current account balance; I certainly expect this effect to become more visible soon. I hope to soon start charting cumulative contributions from real net exports too. Finally, I think there is now growing technical consensus that FDI flows are deeply distorted by tax—most flows globally are to and from a low tax jurisdiction, and even after the tax reform, most of the profits booked by U.S. firms abroad continue to appear in a few low tax jurisdictions, and well, the resulting data distortions are getting pretty big. I am pretty confident the U.S. tax reform didn’t solve the issue of profit-shifting. Now if there were just a consensus on what to do to fix the problem. I want to do a bit more on the role tax arbitrage plays in the generation of dark matter (to use Hausmann and Sturzenegger’s phrase) going forward—and to get back to writing on the Eurozone a bit more. And I plan to continue delving into the risks hiding on the balance sheets of Asian insurers. Japan is almost as interesting as Taiwan. But with $200 billion in tariffs on China lined up for early September, I have a feeling that I may not be able to entirely escape trade. Especially as China’s retaliation against the U.S. will really start to bite when the harvest comes in. Endnotes ^ I am impressed that the IMF determined that Argentina was not sustainable with a high probability—and still found enough flexibility inside the latest access decision to provide large scale financing without a bond restructuring (on the sensible grounds that most of Argentina’s bonds were already long-term and thus the bond holders were not a source of short-term balance of payments pressure). I worried that the IMF would be compelled by the new access policy to find most countries sustainable with a high probability. ^ The reserve metric consistently overstates the reserve needs of Asian surplus economies and consistently understates the reserve need of liability dollarized emerging economies with current account deficits. This is largely because the ratio of m2 to GDP varies enormously across countries. High savings Asian economies tend to have high m2 to GDP ratios and thus current account surpluses, and low saving emerging economies with small domestic banking systems tend to have both external deficits and a high level of liability dollarization. Reserves to short-term external debt, or even a “naïve” variable like reserves to GDP, works better.

var divElement = document.getElementById('viz1532315434641'); var vizElement = divElement.getElementsByTagName('object')[0]; vizElement.style.width='600px';vizElement.style.height='497px'; var scriptElement = document.createElement('script'); scriptElement.src = 'https://public.tableau.com/javascripts/api/viz_v1.js'; vizElement.parentNode.insertBefore(scriptElement, vizElement);       The “law of one price” holds that identical goods should trade for the same price in an efficient market.  But how well does it actually hold internationally? The Economist magazine’s Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to measure the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose. But the law of one price assumes there are no restrictions on, or costs involved in, the movement of goods, and Big Macs travel badly. So in 2013 we created our own Mini Mac Index, which compares the price of iPad minis across countries. Minis are a global product that, unlike Big Macs, can move quickly and cheaply around the world. As explained in the video here, this helps equalize prices. As shown in the graphic at the top, the Mini Mac Index suggests that the law of one price holds far better than does the Big Mac Index. The dispersion of prices is much narrower when measured by Minis. The Big Mac Index shows the dollar overvalued against most currencies, by an average of 37 percent (a Whopper). The euro is undervalued by 14 percent, the South Korean won by 27 percent, the Japanese yen by 36 percent, the Chinese RMB by 44 percent, and the Mexican peso by 53 percent. This certainly accords with President Trump’s narrative—that the dollar is too strong, that other countries are manipulating their currencies for competitive advantage, and that dollar overvaluation is fueling America’s trade deficit. In contrast to the Big Mac Index, our Mini Mac Index actually shows the dollar undervalued—though only by 3 percent on average (small fries). The euro is overvalued by 6 percent, the South Korean won by 5 percent, the Chinese RMB by 4 percent, and the Mexican peso by 12 percent. Among America’s usual suspects for currency manipulation, only Japan has an undervalued currency—by 6 percent. In short, we think the president should hold the relish. His claims don’t cut the mustard.

Emerging markets have come under a bit of pressure recently, with the combination of the dollar’s rise and higher U.S. ten year rates serving as the trigger. The Governor of the Reserve Bank of India has—rather remarkably—even called on the U.S. Federal Reserve to slow the pace of its quantitative tightening to give emerging economies a bit of a break. (He could have equally called on the Administration to change its fiscal policy so as to reduce issuance, but the Fed is presumably a softer target.) Yet the pressure on emerging economies hasn’t been uniform (the exchange rate moves in the chart are through Wednesday, June 13th; they don't reflect Thursday's selloff). That really shouldn’t be a surprise. Emerging economies are more different than they are the same. With the help of Benjamin Della Rocca, a research analyst at the Council on Foreign Relations, I split emerging economies into three main groupings: Oil importing economies with current account deficits Oil importing economies with significant current account surpluses (a group consisting of emerging Asian economies) And oil-exporting economies It turns out that splitting Russia out from the oil exporting economies makes for a better picture. The initial Rusal sanctions were actually quite significant (at least before Rusal got a bit of a reprieve).   And, well, Mexico is a bit of a conundrum, as it exports (a bit) of crude but turns into a net importer if you add in product and natural gas.     But there is clearly a divide between oil importers with surpluses (basically, most of East Asia) and oil importers with deficits. The emerging economies facing the most pressure, not surprisingly, are those with growing current account deficts and large external funding needs, notably Turkey and Argentina. In emerging-market land, at least, trade deficits still matter. In fact, those that have experienced the most depreciation tend to share the following vulnerabilities: A current account deficit A high level of liability dollarization (whether in the government’s liabilities, or the corporate sector) Limited reserves Net oil imports Relatively little trade exposure to the U.S., leaving little to gain from a stimulusinduced spike in U.S. demand Doubts about their commitments to deliver their inflation targets, and thus the credibility of their monetary policy frameworks. It is all a relatively familiar list. Though to be fair, Brazil has faced heavy depreciation pressure recently even though it has brought its current account down significantly since 2014.*  Part of the real’s depreciation is a function of the fact that Brazil and Argentina compete in a host of markets, and Brazil must allow some depreciation to keep pace with Argentina. Part of it may be a function of market dynamics too, as investors pull out of funds with emerging market exposure, amplifying down moves. And of course, part of it comes from increasingly pessimistic expectations for Brazil’s ongoing economic recovery—driven by uncertainty ahead the coming presidential elections together with a quite high level of domestic debt. And for Mexico, well, elections are just around the corner and uncertainty about the future of NAFTA can’t be helping… * Brazil also benefits from having much higher reserves than either Turkey or Argentina.  Its reserves are sufficient to cover the foreign currency debt of its government as well as its large state banks and firms in full.  This has given the central bank the capacity to sell local currency swaps to help domestic firms (and no doubt foreign investors holding domestic currency denominated bonds) hedge in times of stress.  But Brazil's reserve position is a topic best left for another time.

    

I increasingly suspect my view on Chinese “rebalancing” is at odds with the current consensus (or perhaps just with a plurality of the investment bank analysts and financial journalists who watch China). In two significant ways. One. I think China’s balance of payments position is fairly robust. In both a “flow” and a “stock” sense. The current account isn’t that close to falling into a deficit (and it wouldn’t be that big a deal if China did have a modest deficit). And China’s state is back to adding to its foreign assets in a significant way. The days of “China selling reserves” are long past. And two, I think the rebalancing that has lowered the measured current account surplus is more fragile than most think. It is a function of policies—call it a large off-budget “augmented” fiscal deficit or excessive credit growth—that some believe to be unsustainable, and many think are unwise. The IMF, for example, wants China to bring down its fiscal deficit and slow the pace of credit growth, policies that directionally would raise not lower the current account surplus. I think these views are consistent—I tend to think that China’s current account surplus has come down by a bit less than many, but it has come down. Yet the way it has come down (through higher investment rather than a large fall in savings) doesn’t create confidence that it will stay down. China hasn’t embraced the set of policies needed for a more durable rebalancing, notably centralizing and expanding the provision of social insurance and creating a far more progressive tax system that relies less on regressive scoial contributions (payroll taxes). Let me try to document both points. The continued robustness of China’s balance of payments The Economist has highlighted the deficit in China’s current account in the first quarter. The Financial Times has noted that China doesn’t appear to be intervening in the foreign exchange market (though one measure of intervention, FX settlement, did suggest someone was buying in April, rather surprisingly). Many—from the IMF to Paul Krugman—have emphasized that the bulk of the global balance of payments surplus is now found in aging advanced economies (e.g. not China). I would highlight two competing points: A: China’s manufacturing surplus remains large, and shows no sign of falling at current exchange rates. China’s annual manufacturing surplus is still around $900 billion (for comparison, Germany’s manufacturing surplus is around $350-400 billion depending on the exchange rate and the U.S. deficit in manufacturing is around $1 trillion) and doesn’t show any sign of falling. I don’t see signs that the (modest) real appreciation this year will seriously erode China’s competitiveness—though it should moderate China’s export outperformance (Chinese goods export volumes grew at a faster pace than global trade in 2017). China naturally will export manufactures and import commodities. Some surplus in manufactures is normal. And since it is now the world’s largest oil importer, its overall balance increasingly will swing with the price of oil. Every $10 a barrel price rise increases China’s oil and gas import bill by about $30 billion and pulls the surplus down by roughly that amount in the short-run (what matters for the current account is the price of oil relative to spending in the oil importing countries, but in the short-run, a rise in oil prices raises oil exporters income more than spending). And China exports to manufactures to pay for its imports of “vacations”– though its deficit in tourism is almost certainly somewhat smaller than the inflated number in the official Chinese data.  No matter—China’s very real surplus in manufactures continues to provide real support for China’s overall balance of payments. And I have no doubt that China could slow the outflow of tourism dollars (or yuan) if it really was worried about its current account. B: China is once again adding to its reserves. A current account surplus would still be associated with weakness in the overall balance of payments if the surplus was smaller than needed to finance a large underlying pace of private capital outflows—as was the case after China’s 2015 devaluation/ cum depreciation. But here too I think China’s position is fairly strong. Net private outflows have fallen, and China’s state is again accumulating foreign assets. To be sure, the reported foreign exchange reserves on the PBOC’s yuan balance sheet aren’t growing—and that’s an important data point. But in the balance of payments, reserves are growing—they were up about $90 billion in 2017, and are up by $120 billion in the last four quarters of data. The discrepancy between the balance of payments and the PBOC’s balance sheet is a bit mysterious. Interest income is the most obvious explanation. Yet $120 billion in interest income seems a tad high, as it implies China has found a way to earn about 4% on its $3 trillion in reported reserves (though Trump’s fiscal policy should eventually make China’s interest income great again … as it should push up the interest rate the U.S. pays on its external debt).   Broader measures of official asset growth that count lending by the state banks and the buildup of the foreign bonds held by the state banks and the foreign equity held by the CIC and China’s various social security funds show an even larger buildup. Full data isn’t yet available for q1, but there is no real doubt that the state banks have continued to add to their external portfolio (there is data on the foreign currency assets of the state banks). To be sure, some of the foreign lending of the state banks is financed now by their borrowing from abroad—policy lending is no longer all about absorbing the current account surplus. That’s math—a $150 billion external surplus (2017 number) cannot finance both $90 billion in reserve growth (2017 number), $100 billion or so in state bank purchases of foreign bonds/policy lending, and $200 billion in outflows through errors and omissions. There is more going on. But the big and growing balance sheet of the state bank system does provide China with lots of hidden scope to manage the exchange rate in subtle ways. The reported foreign currency assets of the state banks—bonds, and overseas loans—now top $600 billion; the balance of payments data if anything suggests a larger stock of offshore claims. Sum it up, and China’s state continues to sit on the biggest pile of external assets in the world—and that pile has grown significantly in the past 18 months. By my measure that China's state has well over $4 trillion in foreign assets, and its total holdings will be back to its pre-devaluation, pre-reserve fall level by the end of this year. A small external deficit—say from an oil shock combined with a trade war with the U.S.—consequently shouldn’t put China’s exchange rate management at risk unless it creates expectations that Chinese policy makers now want a weaker exchange rate. The fragile rebalancing The argument that China’s rebalancing—the fall in its external surplus—is fragile is actually quite simple. China still saves closer to a half of its GDP than a third of its GDP. And as long as that’s true, avoiding a large current account surplus takes rather exceptional policies, policies that look imprudent and dangerous as they will inevitably result in the buildup of internal debt (see Appendix 2 of the IMF's 2017 staff report, among others).   Back in 2000, China was saving and investing around 35 percent of its GDP (the current account was in a modest surplus so savings was a tad higher than investment). In 2017 (and in 2018), even with the recent progress raising consumption, China is projected to save and invest around 45 percent of its GDP. That’s a level of both savings and investment that remains about ten percentage points higher than in 2000. It is still a substantially higher level of savings and investment than has historically been found in high savings Asian economies (setting Singapore aside, as Singapore never disburses the wealth accumulated in Temasek and the GIC). If investment were to fall back to its 2006-08 level of around 40 percent of China’s GDP and savings were to follow the IMF’s forecast, the current account in 2000 would be around 4 percent of China’s GDP, or well over $500 billion. Four percent of GDP doesn’t sound huge—but it would be a record current account as a share of the GDP of China’s trading partners.* And so long as savings is above 40 percent of GDP there is always a risk that the gap between saving and investment could be even bigger. Yet the IMF—reflecting a global consensus—wants China to scale back the growth in its great wall of (internal) debt (yes, that was meant as a reference to Dinny McMahon's book). The Fund—and many others—didn’t think China’s 2016 fiscal stimulus was a good idea, even though that fiscal stimulus likely played a key role in bringing China’s external surplus back under two percent of China’s GDP after the fall in the oil price.* It now wants “less public investment, tighter constraints on SOE borrowing, and [curbs on] the rapid growth in household debt.” That’s the kind of policy recommendation that the Fund typically makes for a country with a large external deficit—it sounds completely reasonable for say Turkey. But for China, such a fall in domestic absorption would mean a return to a large external surplus—unless, as the Fund recognizes, it is accompanied by a serious effort to reduce savings and raise consumption. Yet there is a risk that when China scales back what no doubt is an inefficient level of investment it will end up doing so without adopting the kinds of policies needed to bring down national savings. Neither Liu He nor President Xi has shown much interest in expanding China’s social safety net, or extending real social protection to China’s migrant workers. This isn’t entirely a theoretical risk. Cutting public investment while residential investment was falling without providing policy support for consumption led to a sharp rise in China’s current account surplus in 2014 and 2015, though the full scale of the rise was masked by some shifts in how China measures its current account. A policy agenda built around supply side reform (with Chinese characteristics) consequently scares me a little bit. So long as China saves so much, it also has an underlying problem with internal demand. * If China's current account surplus had remained constant at its 2007 level as a share of non-Chinese world GDP it would now be a bit over $400 billion (and China's hasn't far from that level in 2015 after adjusting for the inflated tourism number).  If China's surplus had remained constant as a share of China's GDP at its 2007 level is would now be about $1.2 trillion.  The choice of scale variable matters: China's current account surplus could not have realistically remained at its 2007 level as a share of China's GDP without causing tremedous global disruption.  ** See for example paragraph 4 of the 2016 article IV staff report, and paragraph 4 of the 2017 staff report.  The Fund was has been fairly clear (see paragrpah 8) that it viewed the substantial fiscal loosening between 2014 and 2016 ("general government net borrowing widened by 2¾ percent of GDP between 2014 and 2016, driving a similar increase in the “augmented” deficit which reached an estimated 12¼ percent") as a mistake as it put China's "augmented" fiscal deficit on an unsustainable trajectory.  

Korea has indicated that it will, very gradually, start to disclose a bit more about its direct activities in the foreign exchange market. The Korean announcement presumably was meant to front-run its currency side agreement with the United States. Optics and all—better to raise your standard of disclosure unilaterally and then lock in your new standard in a trade deal than the reverse. The problem is…Korea’s actual disclosure commitment is underwhelming. If this is all the U.S. is getting out of the side agreement, it is a bad deal. It sets too low a bar globally, and fails to materially increase the amount of information available to assess Korea’s actions in the market. Many emerging markets disclose their purchases and sales (separately) monthly, with a month lag. India for example (see the RBI monthly data here [table 4] and here). That should be the basic standard for any country that wants a top tier trade agreement with the U.S. Remember, the agreement is about disclosure only—it isn’t a binding commitment not intervene. What has Korea agreed to? A lot less. For the next year or so, it will disclose its net intervention semi-annually, with a quarterly lag. That means data on Korea’s purchases next January this won’t be available until the end of September, and January’s purchases will be aggregated with the purchases and sales of the next five months—blurring any signal.* Korea will start to disclose quarterly with a quarter lag at the end of 2019. But that’s still a long lag. Intervention in January 2020 wouldn’t be disclosed until the end of June 2020. Moreover, quarterly disclosure of net purchases doesn’t provide much information beyond what is already disclosed in the balance of payments (BoP). The BoP shows quarterly reserve growth, which combines intervention and interest income, with a quarter lag. Now is it true that quarterly intervention with a quarter lag was the standard in the TPP side agreement. But the Trump Administration has claimed that TPP was a bad deal, and they would do a better deal. They don’t seem to have gotten that out of Korea. And currency intervention should have been a real focus in the negotiations with Korea. There is no doubt Korea intervenes, at times heavily. And I am confident that the absence of any currency discipline in the original KORUS has had a real impact. Korea, in part through intervention, has kept the won weaker than it was prior to the global crisis. And the won’s weakness in turn helped raise Korea’s auto exports, and thus contributed to the increase in the bilateral deficit that followed KORUS. To be sure, Korea’s German style fiscal policy has also contributed to Korea’s overall surplus. But that isn’t something that realistically can be addressed in a trade deal. Moreover, the failure to get a higher standard than TPP undercuts the Trump administration’s argument for bilateral deals. A big, multi-country deal can in theory be held up by a few reluctant countries. Singapore, for example, has made no secret of its opposition to a high standard for the disclosure of foreign exchange intervention (see end note 4 in the currency chapter of the draft TPP agreement; I assume exceptions to quarterly disclosure didn’t arise by accident). Singapore also discloses comparatively little about the activities of the GIC. And a bilateral deal in theory also could address country-specific currency issues—like the activities of Korea’s large government pension fund. A reminder: Korea’s government-run pension fund is building up massive assets, placing a growing share of those assets abroad and reducing its hedge ratio (it is now at zero, or close to it). This at times has looked a bit like stealth intervention. And it certainly has an impact on Korea’s external balance—structural, unhedged outflows of well over a percentage point of Korea’s GDP have helped Korea to maintain a sizeable current account surplus with less overt intervention. And I worry that the pension fund’s balance sheet will in the future provide Korea with an easy way to skirt the new disclosure standard—particularly if Korea would be at risk of disclosing a level of intervention that might raise concerns about manipulation. Suppose the Bank of Korea bought a bit too much foreign exchange in the first two months of a quarter. The Korean government could encourage the pension fund to buy a couple of billion more in foreign assets in the third month of the quarter, and meet that demand through the sale of foreign exchange from the intervention account. Voila, less disclosed intervention. Remember, sales don’t need to be disclosed separately. A bilateral deal in theory could have included commitments disclose the pension service’s foreign assets, and its net foreign currency position vis-à-vis the won (e.g. its hedges, if any). It thus could have set a standard not just for disclosure of direct intervention, but also for disclosure by sovereign wealth and pension funds. The side agreement on currency with Korea consequently looks to be to be a missed opportunity for sensible tightening of disclosure standards, on an issue that really matters for the trade balance.     Now for some super technical points. The intervention data should not precisely match the reserves data. When Korea buys foreign exchange, it sometimes then swaps the foreign exchange with the domestic banks for won. This lowers the net amount of foreign exchange the central bank ends up directly holding, while creating a future obligation to buy back the dollars swapped for won. This shows up in the central bank’s reported forward book. Total intervention thus may exceed the change in reserves in the balance of payments. However, it can be inferred from the combined increase in reserves and forwards—and Korea currently releases both its forwards monthly and its balance of payments data monthly. As a result its intervention can be inferred from these monthly numbers—quarterly data with a quarter lag will add very little. The buildup of government assets abroad—non-reserve government assets that is—now accounts for a significant share of the net outflow associated with Korea’s current account surplus. And with higher oil prices set to lower Korea’s surplus further, that share will grow. As a chart of the net international investment position shows, the rise in the foreign assets by the National Pension Service now accounts for the bulk of the rise in the total foreign assets of the government of Korea. On a flow basis, outflows from insurers are now more important than the pension outflow—however the insurers, unlike the NPS, supposedly hedge. 3. The increased scrutiny of Korea’s management of the won that has come with the negotiation of the currency chapter—and the risk Korea could be named in the foreign exchange report—has had some positive effects. It didn’t keep Korea from intervening pretty massively to block won appreciation in January at around the 1060 mark (and I suspect Korea has bought at a few other times in the first quarter as well). But it does seem to have encouraged the Koreans to take advantage of dollar rallies to sell won and thus hold their net purchases down. In 2015 and 2016 the Koreans didn’t tend to sell dollars unless the won was approaching 1200 (an extremely weak level). In the past few months they have been selling on occasion at around 1100 (or at least not rolling over some maturing swaps and thus delivering dollars to the market). The won’s trading band has been pretty tight. I just think the block at 1060 should disappear.   */ as I understand it, Korea won’t ever disclose its intervention this January—the first disclosed data will be for the second half of 2018.

The IMF’s reserve metric tends to overstate the reserve needs of current account surplus countries with little external debt, and understates the reserve needs of current account deficit countries with lots of external debt.

Irish tax distortions have a material impact on aggregate eurozone economic data.