Don’t Misread the Trade Implications of the Euro Crisis for China

How much does the Greek crisis matter for China? There are, as far as I see, broadly two schools of thought. One school says that the Greek crisis is largely a problem internal to Europe, and its impact on Europe and the rest of the world is too small to matter much. In support they point to limited bilateral trade relationships between China and the most affected European countries.

The second school focuses on the impact of the Greek crisis on the real exchange value of the RMB and the threat of diminished demand in Europe’s deficits countries. Thanks to the collapse of the euro, they point out, the RMB has already revalued in real terms and this, combined with expected weakness in the European market for imports, means that China should be more cautious than ever in adjusting the value of the currency. An article in Monday’s South China Morning Post makes this point:

The yuan has risen strongly against the euro and this appreciation will harm mainland exporters, a Commerce Ministry official said on Monday. Pegged to a rising US dollar, the yuan has appreciated against a trade-weighted basket of currencies in recent months, which many analysts believe could constrain the scope for a possible revaluation of yuan.

Commerce Ministry spokesman Yao Jian did not say how US dollar strength might affect a long-awaited move to resume yuan appreciation, but he highlighted the impact of the weaker euro. “The yuan has risen about 14.5 per cent against the euro during the past four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China’s exports to European countries,” he told a news conference.

Yao Jian’s comments notwithstanding, I think both schools are wrong. The first school makes the typical mistake of misunderstanding and misinterpreting bilateral trade numbers. This is almost certainly the wrong way to understand international trade issues.

The second school is correct in evaluating the impact of the Greek crisis on the global balance of payments, but shunts aside the issue of how the adjustment burden is to be shared globally—basically the members of this school do not see this as China’s problem. In doing so they propose a strategy that may be the exact opposite of what the world, and China, needs. The Greek crisis, rather than reduce the urgency for China to revalue its currency and adjust its trade policy, may on the contrary require that China react much more aggressively than originally planned.

Why? Because any sharp adjustment in trade or capital flows in one part of the world must automatically force a series of equally sharp adjustments elsewhere. I explain why in an earlier post, and in a piece in today’s’ Financial Times Martin Wolf—as usual one of the few analysts who automatically thinks through balance-of-payments implications—makes the same argument. This need to balance implies that the problems in Europe are going to make international trade relations, and especially those between China and its largest trading partners, much tenser. In fact I worry that the sudden and unpredicted speed of the European adjustment will force a resolution of the global imbalances at a far faster pace than I, already pessimistic, was expecting.

Is pressure to revalue abating?

I say pessimistic because I believe China needs many years to adjust, and I had always assumed that the speed of China’s adjustment would be determined largely by political considerations in the US—after all if one side of the imbalance adjusts, the other side has no choice but to adjust just as quickly. This was always likely to be faster that China wanted.

But now the Greek and European crisis may make the global adjustment even faster than that because of the speed with which European finances are unraveling. To put this in context, it is worth noting that, according to an article in Friday’s Bloomberg, India’s Finance Minister, Pranab Mukherjee suggested that China might begin revaluing the RMB around the time of the G20 meeting in Canada this June.

Mukherjee’s comments indicate sustained pressure for a stronger yuan even as Europe’s debt crisis underscores Chinese policy makers’ concern about the durability of the global recovery. Yuan forwards are headed for the biggest weekly gain this year on bets China will soon relax its peg to the dollar.

China, the world’s fastest-growing major economy, halted the currency’s 21 percent, three-year advance against the dollar in July 2008 to help exporters weather recessions in the U.S., Europe and Japan. Authorities in Beijing have kept the currency at about 6.8 to a dollar, a policy that has blunted the competitiveness of Asia’s export-dependent nations, whose currencies have appreciated this year.

Mukherjee, who served as the foreign and defense minister in Prime Minister Manmohan Singh’s cabinet before being appointed as the finance minister, is under pressure from local exporters to use the Group of 20 platform to campaign against China’s currency policy.

As Mukherjee’s comments suggest, pressure continues growing from a number of countries, especially in Asia, for a Chinese revaluation, and for a while it seemed pretty obvious that China was going to begin revaluing very soon.

The events in Greece, however, have undermined expectations dramatically. Among other consequences of the Greek crisis, the discussion about the currency seems to have become more polarized than ever within China, with proponents insisting that revaluation is still necessary for China’s rebalancing (in fact I would say that even without the Greek crisis the recent decline in real Chinese interest rates makes it more necessary than ever), and opponents arguing that the collapse of the euro against the dollar has already caused an effective (and large) RMB revaluation.

Xinhua today, in a front-page piece, makes this argument very explicitly, suggesting that the RMB devaluation will be put on the “back burner.”

The chances of an early revaluation of the renminbi look unlikely and could happen much later than expected, considering that the nation’s trade surplus may see steep erosions due to the European debt crisis and the growing trade protectionist measures against China’s exports, leading economists and experts said on Tuesday.

Earlier estimates were that the nation would allow the renminbi to rise during the second quarter, with overall gains of 3 to 5 percent for the whole year.  Economists now consider such a move unlikely and expect any currency moves to be deferred till the end of the year with a smaller range and overall gains of 2 to 3 percent.

Ministry of Commerce officials had on Monday indicated that the prospects for the nation’s exports were not that hopeful this year and the annual trade surplus may see a big drop. “The improved trade balance will lay a good foundation for China to implement its macro-economic policy and the currency issue should not be too politicized,” said ministry spokesman Yao Jian.

Trade and finance must balance

The argument—very seductive on the surface but also, like many other seductions, a little dangerous—is that with a weak euro the RMB has effectively strengthened against China’s trade partners, so China has “done its bit” to help in the global rebalancing. But I would argue that the problems in Europe, rather than partially resolve RMB undervaluaton, actually make the global rebalancing much more difficult and require more a aggressive, not a less aggressive, response from China. Why? Take a look the table below, which lists the top ten current account surplus countries based on CIA estimates for 2009:

Top ten surplus countries Trade surplus As a % of total surpluses
China 296,200,000,000 26.6%
Japan 131,200,000,000 11.8%
Germany 109,700,000,000 9.9%
Switzerland 79,180,000,000 7.1%
Norway 58,560,000,000 5.3%
Russia 42,080,000,000 3.8%
Netherlands 33,720,000,000 3.0%
Taiwan 31,100,000,000 2.8%
Korea, South 30,380,000,000 2.7%
Hong Kong 28,340,000,000 2.5%

Obviously China leads, with largest trade surplus by far of any country, accounting for just over a quarter of all trade surpluses. This share has been rising steadily, especially since 2004, and also increased during the financial crisis. Japan is a distant second, with a trade surplus less than half that of China’s, followed by Germany.

However if you add up all the European trade surpluses—the largest being, after that of Germany, Switzerland, Norway, the Netherlands, Sweden and Denmark —together they amount to nearly 28% of total trade surpluses, or a little more than China’s trade surplus (I know, I know, not all of these countries are part of “Europe,” but they are nonetheless going to be part of the same economic process). Together these numbers are very large.

These large trade surpluses haven’t mattered much in the global context because within Europe there are also several trade-deficit countries with equally large trade imbalances. The table below lists the eleven largest trade deficit countries in the world.

Top eleven deficit countries Trade deficit As a % of total deficits
United States 380,100,000,000 34.2%
Spain 69,460,000,000 6.2%
Italy 55,440,000,000 5.0%
France 43,670,000,000 3.9%
Canada 36,320,000,000 3.3%
Greece 34,430,000,000 3.1%
Australia 33,310,000,000 3.0%
United Kingdom 32,370,000,000 2.9%
Iraq 19,900,000,000 1.8%
Belgium 18,920,000,000 1.7%
Portugal 18,610,000,000 1.7%

Obviously the US is the largest by far. It accounts currently for just under one-third of all trade deficits. Some research prepared for me by the Corporate Executive Board, and based on IMF numbers, breaks the data down a little differently, and shows that the US currently accounts for about 40% of total trade deficits, down from 70% in 2003.[1] I am not sure what the discrepancy is, but it doesn’t matter much to the rest of this argument.

Besides the US, there are a number of other countries with large trade deficits (and even larger than that of the US relative to national GDP). Most of these are in Europe. If you add up the trade deficits of all the trade-deficit countries in Europe, the sum amounts to just over 26% of total trade deficits.

So who will bear the brunt of the adjustment?

The numbers on both the surplus and deficit sides, in other words, are fairly large, but they net out to a small number. So until now we could pretty much ignore the impact of Europe on the global trade imbalances because on a net basis Europe didn’t seem to matter too much (and it is aggregate numbers, not bilateral numbers, which really matter in this context).

But thanks to the crisis, we are almost certainly going to see a large and rapid adjustment on one side of the internal European imbalance. This necessarily must have an equally large and equally rapid impact elsewhere. Why do I expect a large and rapid adjustment? Because a country cannot run trade deficits if these deficits are not automatically balanced by net capital inflows. The balance of payments always balances.

One consequence of the Greek crisis is that over the next year or two Spain, Italy, Greece and Portugal may all find it much more difficult to attract net capital inflows. Today’s Financial Times, for example, has a very worrying article on the recent Spanish auction:

Spain came close to its first debt auction failure on Tuesday, highlighting the funding problems for weaker eurozone economies.

The government’s difficulties in selling €6.44bn ($7.96bn) in one-year and 18-month bills sparked worries over its 10-year debt auction on Thursday.  Madrid had planned to issue €8bn, but only just attracted that amount of bids, with yields at record highs. This prompted debt managers to reduce the size of the sale by €1.56bn. Normally a government bill auction would be covered at least 1.5 times.

Will southern European countries have trouble attracting capital inflows? Probably. In fact, almost certainly.  In that case, they are all going to see sharp contractions in their current account deficits, exactly equal to the contraction in net capital inflows—and of course if any if these countries experience flight capital, this contraction can be very sharp.  Again, the reasoning behind this is explained in an earlier post.

To get a sense of magnitude, those four countries are the equivalent in trade deficit terms of more than half the US. If we assume that other European countries with large trade-deficits are also going to have to pay down debt, and may even find difficulty in attracting net capital inflows, then roughly 26% of all trade deficits in the world, an amount equal to more than two-thirds of the US trade deficit, are under pressure to contract rapidly.

Why does this matter to China? Because, of course, the global balance of trade must balance. Every dollar reduction in the trade balance of a European trade-deficit country must be matched, either by a dollar reduction in the trade surplus of Germany or some other European country, or by a dollar increase in Europe’s trade surplus.

Which will it be? Probably a combination of both, but the sharp decline in the value of the euro against the dollar makes it likely that we will see much more of the latter than of the former. In fact for may Europeans, the “silver lining” of the Greek crisis is that by pushing down the euro, it is making all of Europe, even countries like Germany that already have locked-in structural trade surpluses, more competitive in the international markets. Europe’s trade surplus is likely to surge.

So where is the countervailing trade impact? Beijing argues that the depreciation of the euro has automatically forced an appreciation of the RMB, and with deteriorating international markets, there is no need for China to accelerate the process. I would argue that with real interest rates declining in China, it is as if the RMB has been depreciating in real terms in order to protect China from the cost of the trade adjustment. China (along with Japan) does not want to bear the brunt of the global adjustment.

A very reluctant US?

So that leaves the US. Most policymakers around the world—while publicly excoriating the US for its spendthrift habits—are intentionally or unintentionally putting into place polices that require even greater US trade deficits.

This cannot be expected to happen without a great deal of anger and resistance in the US. The idea that suffering countries should regain growth by exporting more to the world, and that rapidly growing surplus countries should not absorb much of this burden, will only force the US into even greater deficits as US unemployment rises to reduce unemployment pressure in Europe, China, Japan and elsewhere.

I would be surprised if the US accepted this with equanimity. On the contrary, I expect it will only exacerbate trade tensions and ensure that next year the dispute will become nastier than ever.

To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:

  1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing.  At best they will be able, through official help, to refinance part of their existing liabilities.
  2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
  3. If European trade deficits contact, there must be one or both of two automatic consequences. Either the trade surpluses of Germany and other European surplus countries—larger than that of China and just a little larger in sum than the European deficits must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
  4. We will probably get a combination of the two, but a much weaker euro—combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption—will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
  5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
  6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports—let alone try to grow them most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
  7. The only way for this not to happen is for the deficit countries to intervene in trade themselves. Since the US cannot use interest rates, wage policies or currency intervention to interfere in trade, it must use tariffs.

Tariffs in the US, Asia and probably in Latin America and Europe will rise. These are big numbers and the risk is that the adjustments are likely to occur rapidly. This means the rest of the world will also have to adjust just as rapidly.

I don’t really see how the numbers are going to work. Europe, China and Japan are all implicitly demanding that the US trade deficit rise to help them through their domestic employment problems. The US has its own domestic employment problems and is determined to bring the trade deficit down. Both sides cannot win and there doesn’t seem to be much serious attempt at global coordination. In fact the easiest part of any global coordination—that between surplus Europe and deficit Europe—has already degenerated into a nasty round of accusations, counter-accusations and insults.

So the hard part of the global coordination is almost certain to fail. It will take a few months for the impact of the euro weakness and the withdrawal of net financing to deficit Europe to be felt, but it will be felt. Expect trade tensions to get nastier than ever by the end of this year or the beginning of the next.

By the way is there anything that China can do to head off conflict? Yes. It can buy euros, the more the better—just lift every offer out there. By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China. Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.

But make no mistake—if southern European trade deficits decline, someone somewhere must bear the brunt of the corresponding adjustment. The only question is who?

Originally published at China Financial Markets and reproduced here with the author’s permission.