Tuesday, March 13, 2012

The Potential Downside of Chinese "Re-balancing": US Inflation

With China recording an unexpectedly huge trade deficit in February 2012, the punditocracy has rushed to opine on the potential effects of Chinese "re-balancing" - i.e., a shift away from economic growth driven by exports and foreign investment (due mainly to relatively cheap labor and currency) to growth driven more by domestic consumption.  Most of the commentary has looked at a "re-balanced" China's potential problems for Chinese exporters and potential gains for US exporters, but I'd like to look at another possible effect of Chinese re-balancing: the loss of two significant, longstanding brakes on harmful inflation in the United States.

Before I get to that, let's dig into China's surprising trade data, courtesy of the WSJ:
A trade deficit of $31.5 billion in February is the largest on record for the world's second-largest economy....

With the lunar holiday for Chinese New Year playing havoc with the data, it makes sense to look at January and February's trade numbers together. On this basis the trade deficit is a less-alarming $4.1 billion-because of a substantial surplus in January-but remains the largest for the first two months of the year since 2004.

Exports grew just 6.8% compared with the first two months of 2011, down from 14.2% growth in the final quarter of 2011. No prizes for guessing the main reason for the fall: exports to Europe contracted 1.1%....

Qu Hongbin, Asia economist for HSBC, notes that growth in processing trade imports fell to 2.4% compared with a year earlier, down from 8.6% in the fourth quarter of 2011. Those imports are the inputs to make China's own exports. Such a low growth rate suggests factories are anticipating weak demand for their products down the line, and going slow on accumulating stock.
Another WSJ article gives us the money graphic:

The article added that "[l]ooking at January and February together, exports rose 6.9%, while imports gained 7.7%, far slower than the double-digit gains China usually chalks up."

So what's causing the sudden shift in China's trade balance?  Well, some of the change is clearly due to falling demand abroad, particularly in crisis-torn Europe (as the WSJ notes), but a broader look at China's exports (courtesy of Michael McDonough) indicates that there may be something bigger and more systemic going on here:

The chart above makes clear that Chinese exports have steadily declined over the last 2 years across the globe, not just in Europe.  I have no idea if this means that China actually has begun to "re-balance," but if China's growth model really is moving towards domestic consumption and away from export-dependence, domestic factors like rising living standards and a stronger currency are likely at play.  If so, that's good news for Chinese consumers and certain US manufacturers that compete directly with China and other low-cost Asian manufacturers.  Unfortunately, there's a downside to these re-balancing factors: they should make it increasingly difficult for the United States to keep inflation at bay.

First, rising labor and other costs in China have made Chinese exports more expensive. This well-documented trend will affect not only China's trade balance, but also US inflation:
Since the 1990s, Chinese imports have helped cool inflation in the U.S. That allowed the Federal Reserve to keep interest rates a bit lower, allowing the economy to grow at a quicker pace.

But with wages rising, the cost of China-made goods has begun to go up. That is bound to continue, and as it does the U.S. economy will look a little more inflation-prone. The Fed's job is going to get more complicated.

The U.S. imported $399 billion in Chinese goods last year, according to the Commerce Department. That was quadruple the $100 billion imported in 2000, the year prior to China joining the World Trade Organization, and ten times the $39 billion imported in 1994.

The jump in Chinese imports has coincided with a period in which inflation has been remarkably quiescent. Over the past 15 years, the core consumer-price index, which excludes food and energy, has risen at an average annual rate of 2.1%, according to the Labor Department, compared with 4% in the 15 years previous.

Much of that downshift owes to a cooling in prices for goods—that is, prices for stuff like t-shirts, which can easily be imported, rather than services like haircuts, which can't. Core consumer-goods prices have increased at an average annual rate of 0.2% over the past 15 years, compared with 2.9% in the 15 years before that.

The Chinese import prices have lately been increasing, however, rising 3.9% last month from a year earlier, according to the Labor Department. Some of that owes to higher commodity costs, but rising Chinese wages and an appreciating yuan also seem to be playing a role. One indication of that: Prices for footwear imports—labor-intensive goods that use a minimal amount of raw material and are mainly made in China—have risen 5.5% over the past year.

While a cooling Chinese economy could offer some temporary respite, China has reached a point in its development where it will be difficult to keep labor costs in check. Some manufacturers are shifting operations to other low-wage Asian countries, but the scope for doing that is limited—there are only 90 million people living in Vietnam compared with China's 1.3 billion.

This isn't to say that rising prices in China will be pushing prices higher in the U.S. Rather, they won't be pulling them down. So the U.S. economy will look a little more inflationary, and a little less productive—a little more like it looked before China entered the scene.
A brand new report from the WSJ indicates that rising Chinese labor costs are having a "ripple effect" on labor costs in other developing Asian economies like Malaysia, Thailand, Indonesia and Vietnam. Thus, the prices of these countries' exports are also on the rise:
More Asian governments are pressing businesses to hike wages as a way to prevent outbreaks of labor unrest, raising the specter of higher manufacturing costs for global companies—and the products they sell world-wide....

Global companies already have been facing higher labor prices in China over the past year, despite a weak global economy, as workers demand a greater share of the country's economic boom. In recent months, the pressure also has intensified in countries across Southeast Asia that have marketed themselves as alternatives for companies seeking to escape China's rising costs, leaving those companies now with fewer places to move....

Asian governments, in some cases, are embracing the call for higher salaries, in part to head off the spread of the kind of unrest that has toppled Middle Eastern regimes recently—and to calm rising labor actions in their countries.

They also are hoping the higher wages will help consumers boost spending, providing a new engine of growth at a time when slack demand for exports in the West and higher oil prices are worrying policy makers across the region.....

The spread of higher wages is likely to present challenges for the companies that have long relied on Asian manufacturing operations to keep their costs low, potentially including multinationals, such as Nike Inc., Adidas AG, Dell Inc. or their suppliers....

Boosting minimum wages risks setting off more inflation at a time when central bankers are worried about increased oil prices. Such a scenario could put the price of ordinary goods out of reach of the people the higher wages are intended to help.

Garment, footwear and electronics manufacturers operating in Indonesia from South Korea, Taiwan and Japan say they are now thinking of taking their factories elsewhere. Some said they fear more wage increases as local politicians try to win votes in elections scheduled over the next two years....

But with wages now rising in so many places at once, unhappy companies may have few places to escape.
If rising Chinese import prices are removing a brake on US inflation, then rising prices of other Asian imports   should have a similar and supplemental effect.

Second, in real terms, the Yuan has appreciated significantly against the US dollar over the last several years.  This appreciation will undoubtedly decrease some Chinese exports and increase domestic import consumption, but it might also have a significant effect on US inflation because of how China manages the value of the Yuan.  As I've repeatedly noted, much of the Yuan's relative appreciation is due to significant Chinese inflation (caused by, among other things, economic growth, rising labor costs and Chinese monetary policy), but some of it is due to a noticeable shift in China's monetary policy, in particular its "managed peg" of the Yuan against the US dollar.  Until last week's trade surprising trade deficit, this change allowed (or forced) the Yuan to appreciate against the Dollar in nominal terms over the last year or so (chart again courtesy of Mr. McDonough):

So why did the Yuan's nominal value appreciate so much last year?  Well, one possible reason is that China stopped buying US government debt.  China helps control the nominal value of the Yuan by purchasing that debt, but the government's purchases slowed dramatically last year:
China's holdings of U.S. Treasuries accounted for 54% of its foreign-exchange reserves as of June 30, according to a U.S. Treasury survey released this week. That's down from 65% in 2010 and a record 74% in 2006....

Beijing continues to buy loads of U.S. debt. As of June 30 it held $1.73 trillion in U.S. securities, up 7% from June 30, 2010.

Still, other federal data show it was a net seller of U.S. treasuries in the second half of 2011.
Bank of America predicts that China will continue to diversify its debt holdings away from US Treasuries in 2012, even though most people expect the Yuan's nominal appreciation to slow this year.  Because global turmoil has made the United States the "debt of last resort," most experts note that China's diversification shouldn't have a huge affect on interest rates (and thus inflation) in the United States right now.  However, China's reduced foreign purchases of US Treasury Bills could eventually bite, as this new report from the Federal Reserve makes clear:
Foreign offi cial holdings of U.S. Treasuries increased from $400 billion in January 1994 to about $3 trillion in June 2010. Most of this growth is accounted for by a handful of emerging market economies that have been running large current account surpluses. These countries are channeling their savings through the offi cial sector, which is then acquiring foreign exchange reserves. Any shift in policy to reduce their current account surpluses or dampen the rate of reserves accumulation would likely slow the pace of foreign offi cial purchases of U.S. Treasuries. Would such a slowing of foreign o cial purchases of Treasury notes and bonds a ect long-term Treasury yields? Most likely yes, and the eff ects appear to be large.
The aforementioned Bank of America report echoes these concerns.  So, in short, should the Chinese government stop buying US debt in order to allow (or force) the Yuan to appreciate, an unfortunate - but totally expected - byproduct could be higher interest rates and increased inflation in the United States.

There are growing concerns from several reputable, non-partisan sources that inflation could become a real problem in the United States over the next year or so.  (Sky-high energy costs and ridiculously easy money can do that to a country.)  At the same time, President Obama and his administration are relentlessly pushing China to re-balance its export-dependent economy.  As noted above, part of that re-balancing process will undoubtedly involve more expensive Chinese (and other Asian) imports into the United States and also could involve fewer Chinese government purchases of US debt.  But given the potential adverse effects of such events on the inflation-prone US economy, advocates of Chinese re-balancing in the administration and elsewhere may want to recall an old bit of wisdom:

Be careful what you wish for.

1 comment:

Rachel S said...

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