China & Trade Balances

Strange though it may seem China is close to a trade deficit. This has wide-ranging implications - make sure you are aware of them:

That china sells more to the world than it buys from it can seem like an immutable feature of the economic landscape. Every year for a quarter of a century China has run a current-account surplus (roughly speaking, the sum of its trade balance and net income from foreign investments). This surplus has been blamed for various evils including the decline of Western manufacturing and the flooding of America’s bond market with the excess savings that fuelled the subprime housing bubble.

Yet the surplus may soon disappear. In 2019 China could well run its first annual current-account deficit since 1993. The shift from lender to borrower will create a knock-on effect, gradually forcing it to attract more foreign capital and liberalise its financial system. China’s government is only slowly waking up to this fact. America’s trade negotiators, meanwhile, seem not to have noticed it at all. Instead of focusing on urging China to free its financial system, they are more concerned that China keep the yuan from falling. The result of this myopia is a missed opportunity for both sides.

China’s decades of surpluses reflected the fact that for years it saved more than it invested. Thrifty households hoarded cash. The rise of great coastal manufacturing clusters meant exporters earned more revenues than even China could reinvest. But now that has begun to change. Consumers are splashing out on cars, smartphones and designer clothes. Chinese tourists are spending immense sums overseas (see article). As the population grows older the national savings rate will fall further, because more people in retirement will draw down their savings.

Whether or not China actually slips into deficit this year will be determined mostly by commodities prices. But the trend in saving and investment is clear: the country will soon need to adjust to a new reality in which deficits are the norm. That in turn means that China will need to attract net capital inflows—the mirror image of a current-account deficit. To some extent this is happening. China has eased quotas for foreigners buying bonds and shares directly, and made it simpler for them to invest in mainland securities via schemes run by the Hong Kong Stock Exchange. Pension funds and mutual funds all over the world are considering increasing their exposure to China.

But the reforms remain limited. Ordinary Chinese citizens face restrictions on how much money they can take out. If many foreign investors tried to pull their money out of China at once it is not clear that they would be able to do so, an uncertainty that in turn may make them nervous about putting large sums in. China is terrified of financial instability. A botched currency reform in 2015 caused widespread volatility. But the system the country is moving to, which treats locals and foreigners differently, promises to be leaky, corrupt and unstable.

Eventually, then, capital will need to flow freely in both directions across China’s borders. That is to be welcomed. People outside and inside China will benefit from being able to invest in more places. The need for freer capital flows will have the welcome side-effect of forcing China to reform its state-dominated financial system, not least so that it commands confidence among international investors. This in turn will mean that market forces play a bigger role in allocating capital in China.

You might expect America’s trade negotiators to welcome all of this, and urge China to free its financial system. Unfortunately they seem stuck in the past. Obsessed with the idea that China might depress its currency to boost exports, they are reportedly insisting it commit itself to a stable yuan. That is wrong-headed and self-defeating. Rather than fighting yesterday’s currency wars, America should urge China to prepare for the future.

CRITICAL READING YEAR 13!

NOT because the author is a Brexiteer, but because the points he makes, connecting different economic issues, work very effectively as analysis and evaluation. If you can stitch together the various elements he puts in here, you will be able to answer questions to do with this area (trade blocs, economic union, single currencies) more effectively - as well as understand one of the critical issues of toady:

We have just passed the euro’s 20th anniversary. I am not going to rehearse the ways in which the euro has been a disaster. Instead, I want to ask why it was formed in the first place and how European elites failed to perceive the pain that it would bring. The answers have important lessons for us now, as we contemplate our future relationship with the EU. 

From the beginning, the formation of the euro was seen by the European elites as part of the political project of integration, leading eventually to a federal European state. It was widely believed that sharing a common money, with all its implications for interest rates, fiscal policy and umpteen other things, would be both an expression of European unity and a major force for cementing it.

Once it subsequently became clear that the economy of the eurozone was experiencing considerable difficulties, it was common for European political leaders to claim that, as a political project, it had always been recognised that the formation of the euro would bring serious economic costs.

They argued that these had to be borne in order to achieve the political objective. Indeed, some went further and claimed that without the euro the whole EU edifice might collapse. The implication was that although things might seem pretty grim in a number of eurozone members, this was a necessary price to pay.

But this notion was complete bunkum. Although the primary motive for forming the euro was political, before its formation, key European leaders trumpeted the supposed economic benefits of the single currency. They believed that it would bring significant gains through a reduction of transactions costs and uncertainty, the deepening of financial markets and the imposition of good economic governance. 

Where did they go wrong? Right at the beginning. The politicians and officials driving the European project generally understood very little about economics. 

Indeed, it has to be said that quite a few of their supporting economists apparently understood little about economics either. The most significant error was to believe that it was the deutschmark that gave Germany its overbearing position in Europe. Take that away and Germany would be cut down to size, and Europe would become more balanced and harmonious. 

This was a misconception. In fact, it was precisely the deutschmark that kept Germany in check. Then, as now, Germany had a decided tendency towards tremendous success with its exports, combined with over-saving.

If left unchecked, this would lead to an enormous German current-account surplus, forcing other countries into deficit.

A rising deutschmark was the mechanism that prevented this from happening. The higher German currency both attenuated the strength of German exports and, by keeping down the costs of imports, increased German workers’ real incomes, which they largely spent.

The euro has robbed the European economy of this crucial adjustment mechanism. The result is a German current-account surplus approaching 8pc of GDP, alongside slow growth of German real wages and sluggish growth of consumers’ expenditure. Combined with enforced austerity in the deficit countries, this has imparted a strong deflationary force to the European economy, reminiscent of the Gold Standard in the 1920s and 1930s.

There were three other key misjudgements. First, euro supporters greatly overestimated the gains from reducing transactions costs and uncertainty about currency values. In the modern world, companies are readily able to deal with such costs and uncertainties. So the gains from monetary union have been tiny.

Second, they greatly overestimated the ability and willingness of all eurozone member countries to adjust their price and wage setting and to reform their economic structures to enable them to cope with a fixed exchange rate. So the losses have been huge. 

Third, they did not understand the implications of allowing debt ratios to rise significantly in countries which, once they had joined the euro, would no longer be able to issue their own money. As a result, Italy is heading for some sort of financial blow-up and possible default. So the system is seriously unstable.

Yet prior to the euro’s birth in 1999, in the debate in this country about whether Britain should join, most of the establishment – led by Tony Blair, the Prime Minister at the time – was strongly in favour. This group included the CBI, representatives of big business and the City, with support from the BBC, most major media outlets and large parts of the civil service.

They envisaged serious economic decline, or even disaster, if the UK stood aside. We now know that their views were comprehensively wrong.

Does this ring a bell? It should – an alarm bell. Now we stand on the brink of another momentous decision. And the same people are still peddling the same sort of nonsense.

 Yesterday’s “transactions costs and uncertainty” is today’s “border frictions and disruptions”. Yesterday’s supposed need for a common currency in order to make the trading union work is today’s supposed need for a “deal” with the EU in order to enable us to trade with it.

And there seems to be a blatant disregard of the facts. Contrary to what the Remainers blithely assume, the EU’s economic performance compared with other developed countries has been poor. This is for a good reason. The EU makes bad decisions.

Its institutions don’t work very well and it pursues a political agenda, either ignorant of the economic costs or oblivious to them. The euro is creaking and the European elites are hurtling towards more disastrous decisions. Meanwhile, the EU falls further behind the rest of the world.

We escaped membership of the euro by the skin of our teeth. We now need to grit those teeth to escape fully and finally from the very entity that conceived of the euro monstrosity in the first place. In case you were in any doubt, Mrs May’s capitulation of a “deal” would bring not a full and final escape, but rather a further entrapment.

Roger Bootle is chairman of Capital Economics;  roger.bootle@capitaleconomics.com

What's happening in Germany?

Bit of a trawl through data, but some key nuggets for you (highlighted); you have to read it all to understand it, but the last section is very clear:

The outlook for the economy of Germany has plenty of dark clouds

Posted on January 9, 2019

Sometimes it is hard not to have a wry smile at the way events are reported. Especially as in this instance it has been a success for my style of analysis. If we take a look at the fastFT service we were told this yesterday:

German industrial production unexpectedly drops in November.

My immediate thought was as the German economy contracted by 0.2% in the third quarter we should not be surprised by declines. Fascinatingly the Financial Times went to the people who have not been expecting this for an analysis of the issue.

German data released over the past two days have painted a glum picture for how Europe’s biggest economy performed during the latter part of 2018. fastFT rounds up what economists and analysts have said about what is happening. Anxieties over global trade wars and political uncertainty in the eurozone have taken their toll, and Europe’s powerhouse is showing signs of fatigue. Questions of whether a recession is looming have also been raised, while many economists remain cautiously optimistic in their prognosis.

If we now switch to what we have been looking at I wrote this on December 7th about the situation.

If we look at the broad sweep Germany has responded to the Euro area monetary slow down as we would have expected. What is less clear is what happens next? This quarter has not so far show the bounce back you might expect except in one area.

So not only had there been an expected weakening of the economy but there had been at that point no clear sign of the promised bounce back. What we know in addition now is this which was released on January 3rd.

• Annual growth rate of broad monetary aggregate M3 decreased to 3.7% in November 2018 from 3.9% in October
• Annual growth rate of narrower monetary aggregate M1, comprising currency in circulation and overnight deposits, stood at 6.7% in November, compared with 6.8% in October

So another decline and if we look for a trend we would expect Euro area growth to continue to be weak and this time around that is being led by Germany. The link between monetary data and the economy is not precise enough for us to say Germany is in a recession but we can expect weak growth at best heading into the early months of 2019. The FT does to be fair give us a brief mention of the monetary data from Oxford Economics.

lending growth remaining robust

The problem with that which as it happens repeats the argument of Mario Draghi of the ECB is that it is a lagging indicator in my opinion as banks respond to the better economic news from 2017.

As these matters can be heated let me make it quite clear that I wish Germany no ill in fact quite the reverse but the money supply data has been clear and has worked so far. Frankly the way it is still being widely ignored suggests it is likely to continue to work.

This week’s data

Trade:

This morning’s release started in conventional fashion as we got the opportunity to observe yet another trade surplus for Germany.

 Germany exported goods to the value of 116.3 billion euros and imported goods to the value of 95.7 billion euros in November 2018………The foreign trade balance showed a surplus of 20.5 billion euros in November 2018. In November 2017, the surplus amounted to 23.8 billion euros. In calendar and seasonally adjusted terms, the foreign trade balance recorded a surplus of 19.0 billion euros in November 2018.

In world terms an annual decline in Germany’s surplus is a good thing as it was one of the imbalances which set the ground for the credit crunch. But if we switch to looking at this on a monthly basis this leapt off the page at me about imports.

-1.6% on the previous month (calendar and seasonally adjusted)

A fall in imports is a sign of a weak economy as for example we saw substantial falls in Greece back in the day. There are caveats to this of which the biggest is that monthly trade data is inaccurate and erratic but such as the numbers are they post another warning. The other side of the balance sheet was more conventional in that with current trade issues one might expect this.

also reports that German exports in November 2018 remained nearly unchanged on November 2017.

Let us move on by noting that due to the way that Gross Domestic Product or GDP is calculated lower imports in isolation provide a boost before a “surprise” fall later as it filters through other parts.

Production

If we step back to Monday there was some troubling news on this front.

Based on provisional data, the Federal Statistical Office (Destatis) reports that price-adjusted new orders in manufacturing had decreased in November 2018 a seasonally and calendar adjusted 1.0% on the previous month.

So not much sign of an improvement and it was hardly reassuring that geographically the issue was concentrated in the Euro area.

Domestic orders increased by 2.4% and foreign orders decreased by 3.2% in November 2018 on the previous month. New orders from the euro area were down 11.6%, new orders from other countries increased 2.3% compared to October 2018.

Then on Tuesday we got disappointing actual production numbers.

In November 2018, production in industry was down by 1.9% from the previous month on a price, seasonally and calendar adjusted basis according to provisional data of the Federal Statistical Office (Destatis). The revised figure shows a decrease of 0.8% (primary -0.5%) from October 2018.

So November has quite a fall and this was compared to an October number which had been revised lower. This meant that the annual picture looked really poor.

-4.7% on the same month a year earlier (price and calendar adjusted)

Business surveys

At then end of last week we were told this by the Markit PMI ( Purchasing Manager’s Index) at the end of last week.

December saw the Composite Output Index fall for the fourth month running to 51.6, down from 52.3 in
November and its lowest reading since June 2013.
The latest slowdown was led by the service sector, as the rate of manufacturing output growth strengthened for the first time in five months, albeit picking up only slightly and staying below that of services business activity.

The problem for Markit is that rather than leading events they are lagging them as they are recording declines after the economic contraction in the third quarter. If we took them literally then the economy would shrink by even more this quarter! Anyway they no seem to be on the case of the motor industry. From yesterday.

Latest data indicated a worsening downturn in the European autos sector at the end of 2018. Production of automobiles & parts fell for the third month running, and at the fastest rate since March 2013. New orders fell sharply, with new export business (including intra-European trade) declining at the fastest rate in six years.

Comment

The German economy found itself surrounded by dark clouds as 2018 developed and as I am typing this we have seen more worrying signs. From @YuanTalks.

It’s the FIRST YEARLY DROP in at least 20 years. Passenger car sales slumped 19% y/y in Dec 2018 to 2.26 mln vehicles.

Over 2018 as a whole car sales fell by 6% so we can see the issue is accelerating and there are obvious implications for German manufacturers. It has been accompanied by another generic sign of possible world economic weakness from @LiveSquawk.

Exclusive: Apple Cuts iPhone Production Plan By 10% – Nikkei $AAPL

Suddenly there is a lot of concern over a German recession or as it is being described a technical recession. In case you were wondering that means a recession that is within the error range of the data which actually covers most of them! Because of these errors it is hard to say whether the German economy grew or contracted at the end of last year, as for example wage growth should support consumption. But what we can say is that the broad sweep from it to the like;y trend for the early part of 2019 is weak. Perhaps some growth but not much after all even 0.2% growth in the final quarter would mean flat growth for the second half of the year.

For those who think ECB policy is set for Germany this poses quite a problem as it has ended its monthly QE purchases just as things have deteriorated in a shocking sense of timing. But to my mind just as bad is the issue that my “junkie culture” theme that growth was dependent on the stimulus also gets a tick including something of a slap on the back from Mario Draghi who seems to have come round to at least part of my point of view.

I’ll be briefer than I would like to be, but certainly especially in some parts of this period of time, QE has been the only driver of this recovery.

According to Handelsblatt every little helps.

Germany has saved €368 billion in interest costs on its debt thanks to record low interest rates since the financial crisis in 2008, according to Bundesbank calculations. That’s more than 10% of annual GDP.

Current account deficits, surpluses and more

The first section looks at the German c/a surplus, in a readily digestible way. It also explains Target2 - how the ECB balances out surpluses & deficits within the Eurozone - removing the requirement for individual central banks to hold large reserves. The last section looks at the storm clouds looming in Europe; take from that what you will - the author is a eurosceptic:

Flip side of Italy’s woes is a German economy with a suspect engine

• ROGER BOOTLE
  

21 OCTOBER 2018 • 8:30PM

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Last week I wrote about the inter-relationship between Italy’s financial plight and its underlying economic difficulties, now finding expression in its government’s conflict with the EU. It has been told by the EU to come up with a different budget. If its budget isn’t modified, the EU will probably reject it. We shall see if the Italians bend the knee to Brussels.

But the Italian difficulties represent only one side of the euro problem. The flip side is to be seen in Germany and, contrary to popular misconceptions, it isn’t rosy either. On the face of it, Germany is an amazing economic success story. The economy is growing strongly and unemployment is only 3.4pc.

Yet recent German economic performance is not outstanding. Since the formation of the euro in 1999, Germany’s economy has grown by about 32pc while the poor old UK has grown by 43pc. Meanwhile, the figures for the US and Canada are 49pc and 53pc respectively. In the same period, Sweden has grown by 56pc and Switzerland by 46pc.

Yet it is when you look at the figures for consumption that it really dawns on you that things aren’t quite right. Since 1999, spending by German consumers has risen by only 20pc. How come the discrepancy between GDP and consumption? This is explained largely by the shift in the trade balance. Since the euro was formed, Germany has gone from a small deficit of about 1pc of GDP to a whopping great surplus of almost 8pc of GDP. 

The explanation for relatively weak consumption is largely not more saving by German consumers, whose caution is legendary; rather, German workers have not been paid that much. Since the formation of the euro, the average real pay of German workers has risen by only 23pc, or 1.2pc per annum. It is German companies that have done spectacularly well, largely thanks to strong exports, greatly helped by subdued wage increases and the competitive euro. Meanwhile, the government’s budget is in surplus to the tune of 1.3pc of GDP. The German economy is completely lopsided with excessive reliance on exports and domestic demand too weak. 

But some day German workers will benefit, won’t they? Perhaps. The counterpart to these huge current-account surpluses is the build-up of claims on other countries. These are effectively IOUs from countries that have bought German goods, well in excess of what Germany has bought from them. But debts aren’t always repaid, as Germany should know. 

Within the euro system there is a special sort of IOU. These are the so-called Target2 balances, representing claims by one central bank on another as a result of imbalances in the flow of money between member countries.

This is how it works. Suppose someone withdraws euros from an Italian bank and deposits them with a German bank. The German bank now has surplus euros and the Italian bank has a shortage of euros. Through their respective central banks and the ECB, the euros are recycled from the German bank to the Italian bank. 

But someone has replaced a claim on an Italian bank with a claim on a German bank. Matching this switch, the German central bank has acquired a claim on the ECB and the ECB has acquired a claim on the Italian central bank. That doesn’t sound to me like an equal exchange.

The scale of these claims is staggering. Germany has net claims on other countries within the Target2 system of some €1,000bn. That amounts to roughly 30pc of German GDP. The Target2 liabilities of the Bank of Italy come to almost half that figure. The stock of both German claims and Italian liabilities is far greater now than it was at the height of the euro crisis in 2012. 

If Italy were to leave the euro, would it fully honour these debts? The lawyers will tell you that legally it must. But then that’s why they are lawyers. If I were the ECB I would not want to bank on it – as it were. What will happen if the stand-off between the Italian government and the euro authorities continues and the Target2 balances get ever larger? And suppose that there is a run on the Italian banks. The Bank of Italy cannot issue euros. It would be the ECB that would have to provide the dosh. Would it? These problems for Germany and Europe have arisen from the abolition of the Deutschmark. The exchange rate is a hinge that allows countries as different as Germany and Italy to be different, yet to remain connected. Without it the union must break.  

The replacement of the Deutschmark by the euro has also been responsible for a significant global problem, namely the fact that the eurozone as a whole is running the largest current-account surplus in the world, thereby acting as a deflationary force and contributing to the growth of protectionist sentiment, especially in the US. 

The solution is obvious: bring back the Deutschmark. But I wouldn’t hold your breath. Germany does not want to be the cause of another major European upset. If Germany doesn’t leave the euro, then Italy should. As and when either of these happens there will be financial mayhem across Europe. But carrying on with the current system would be worse.

Apparently the UK’s policy establishment wants us to stay in the EU, if not permanently then at least for as long as possible. If we leave without a deal on a continuing close relationship they are worried about “disruption”. Disruption? Has anyone in Whitehall noticed the storm gathering across the channel? I would have thought that the sensible thing for us would be to clear off out of it PDQ, before the balloon goes up. Still, I am a humble economist, not one of our Olympians charged with the task of managing Brexit. They evidently understand these complex European economic matters in a unique way. 

Roger Bootle is chairman of Capital Economics