As we pointed out a few days ago when we noted that China is about to disclose a March trade deficit, Soc Gen's Albert Edwards was right on the dot, and has been since November. Sure enough, today he (rightfully so) revels in his vindication:
Many clients have congratulated us for flagging up this outturn back in November last year ?- see Global Strategy Weekly 23 November -? link. We said back in November that ?China will be heading into a trade DEFICIT (!) throughout 2010. This is a mega-call and will have major financial market implications?. Unfortunately I have not pushed this call hard enough. Why not? Well, because as the implications are so very non-consensus, I knew noone would take it seriously. With the pre-announcement of March?s deficit, investors are now more willing to listen.
To be sure, only economists who still reference 1984 textbooks and write uninspired columns could not see this coming. Shockingly, this was indeed the dominant view. And inevitably it will take a long time before the ramifications of what a Chinese deficit means, finally sink in.
Edwards attempts to make llife for those whose world is about to be turned upside down, a little easier.
In part, the timing of such an announcement is political, ahead of moves in the US to label China a ?currency manipulator?. Chen said, "China's trade surplus with the US has been turned into a key excuse by American economists to pressurize the Chinese government to revalue the yuan," but, ironically, the calls have been growing stronger even as the "surplus keeps falling". Although the timing of the announcement may be political, the trend towards a sustained trade deficit is very real. It comes on the back of an aggressive stimulus package focused on infrastructure spending which has sucked in massive imports of commodities. The import of these dollar-denominated assets has additionally meant the need for official purchases of dollar-dominated Treasuries has lessened.
Edwards, unlike Stephen Roach, is a little more polite when it comes to Nobel-prize winner extraordinaire, Paul Krugman:
The debate on whether or not China should be revaluing its currency is heating up, not just between the two governments, but also between leading market economists. Stephen Roach, Chair of Morgan Stanley Asia, went so far as to say in a recent Bloomberg interview that ?we should take out the baseball bat on Paul Krugman? -? Roach Spars With Krugman Over Call to Pressure China -? Bloomberg.com. Krugman who has been calling for yuan revaluation responded in his NY Times blog that Roach had gone ?"batty?" -? link. With brick-bats and baseball bats being wheeled around I enter this debate with some trepidation. But I don?t want to get into what China should, or should not do, I want to focus on what I think will happen.
Credit for originating the call that China would move into trade deficit goes to our Asian Economist, Glenn Maguire. I reproduced the front cover chart of his a couple of weeks back with his projections for a trade deficit emerging from March onwards. Glenn doesn?t yet share my conclusions which I believe are likely to flow from this seismic shift in trade imbalances, but I?m still working on him (hmmm, maybe that?s why he avoids me when he visits London).
One of the key changes over the last year is the rate at which Chinese import growth now outstrips export growth (see left hand chart below). It is clear much of this is down to the rapid pace of commodity imports, associated with a step-up in infrastructure projects due to the fiscal stimulus programme, but also with stockbuilding. Hence we see total imports handsomely outstripping imports from countries that are not big commodity producers, such as the US and Europe (see right hand chart below).
Aluminum, Copper and Gold are now the new 10 Year, at least for China. This was substantially proven by the just passed miserable 5- and 7-Year auctions.
Now there are a couple of things I have been mulling over in my mind about these developments. It is well known that China has been buying commodities in excess of its needs for final consumption and stockpiling them. This seems sensible. If you have a pegged exchange rate and have to buy dollar assets, why just pile up mountains of US Treasuries when you can pile up mountains of copper and iron ore that can be usefully consumed at some point in the future? This change in policy also has the added advantage of engaging in FX intervention on the trade account rather than the capital account, thereby relieving intensifying political pressure for a yuan revaluation. Indeed I would suggest that the preannouncement of the March trade deficit is the latest salvo in the ongoing war of words. China can quite reasonably point at its trade deficit and respond to the US that its criticism that the yuan should be revalued is totally invalid if it is running a trade deficit. Some might argue that instead of "?manipulating?" its currency, it is trying to head off pressure to revalue by manipulating its trade balance.
If China is running a trade deficit, it is clear that it will be buying a lot fewer US Treasuries. We find it is widely assumed that this will result in a noticeable rise in US bond yields. But it may not. If China now has a trade deficit, someone else must be running either reduced deficits (the US?) or bigger trade surpluses (commodity producing countries?).
What does this mean for global trade balances:
To the extent that China?s trade surplus is ?'shifted'? elsewhere (e.g. Canada), these countries may be larger consumers of US goods and hence the US may see a quicker reduction of its own trade deficit. If that is the case, the US could become more like Japan, funding purchases of Treasuries out of domestic savings. Or to the extent the commodity nations see larger trade surpluses and do not peg their currencies in the same way as China, they will see intensifying upward pressure on their own currencies, helping to clear recent extreme global imbalances which were at the heart of the recent credit crisis.
Ultimately, though, as EU trade commissioner Karel De Gucht pointed out recently in an FT interview, ?the dispute between the US and China [currently] is part of a bigger issue? (EU?s De Gucht airs concern on US trade stance - FT.com). Tensions have been rising on a number of separate fronts. And as such the US may still name China as a ?currency manipulator? despite a move into trade deficit.
I still make the very simple point I made back in November; a collapse of the current recovery seems extremely plausible in both the US and China in the not too distant future. This will only intensify the mutual belligerence seen in both nations. And despite the recent downturn last year, the yuan has strengthened decisively over the last four years.
I think the emergence of a persistent Chinese trade deficit would fundamentally change the political dynamics between the US and China. If political tensions continue to mount and the US begins to erect trade barriers after naming China as a "?currency manipulator?", at some point China may indeed do exactly as the US authorities wish and stop ?manipulating? its currency. And if it is running large trade deficits, investors should consider the very realistic outcome that China does indeed devalue the yuan.
And another observation: with FX intervention out of the way, the only way to stall an overheating economy (that is merely stockpiling UST alternatives, yet flooding the economy with free money), is to hike rates. The elimination of currency mechanisms to moderate overheating means that monetary policy is the only way, which means that the Bank of China is likely ever so closer to notjust removing excess liquidity, which it has been doing in overnight operations for the past two weeks, but raising the interest rate outright.