My Blog

SAT 12 APR

Tooting my own horn By Michael Pettis

I was just notified today that my blog has been ranked again among the top 100 business and economic blogs, according to Wikio, rising from number 84 last month to number 70 this month.  This kind of thing shouldn't matter, of course, but I have to admit that I am sort of pleased, and also a little puzzled that such a specialized blog should make it onto a list dominated by more macro-oriented blogs.  Perhaps there just isn't a lot of stuff on China, and so I get the default vote.

SAT 12 APR

So many questions about PBoC reserve growth By Michael Pettis

The closer you look at the latest PBoC reserves numbers the more surprising they seem.  Headline reserve growth of $154 billion in the first quarter of 2008 is an astonishing number by any standard and suggests that the PBoC’s ability to manage monetary policy must be under ferocious strain, but it turns out that net foreign currency inflows purchased either by the PBoC or by its proxies may have been much, much higher.  How can they manage?

 

Let’s go through these first-quarter reserve numbers again.  Here is what I think we know with reasonable certainty:

 

1.        For the first three months of 2008 reserve growth was $61.6 billion in January, $57.3 billion in February, and 35.0 billion in March.  This adds up to $153.9 billion.

 

2.        The trade surplus for the first three months of the year was $19.5 billion in January, $8.6 in February, and $13.6 billion in March, for a grand total of $41.6 billion.

 

3.        FDI contributed $11.0 billion in January, $6.9 billion in February, and $9.5 billion in March.  These add up to $27.4 billion.

 

There are other things that we know increased the value of PBoC reserves.  We don’t have precise numbers but we can make reasonably accurate estimates.

 

1.        It is pretty certain that at least part of the PBoC reserves are held in currencies other than US dollars – most experts estimate this portion to be about 30% of reserves, a number that jibes with estimates by CFR’s Brad Setser and Stone & McCarthy’s Logan Wright, two of my favorite experts on the topic.  Logan went through the numbers and tells me that he believes that valuation gains, which occur as the dollar declines against other currencies in the PBoC portfolio, accounted for $10 billion in January, $10 billion in February, and $18 billion in March.  This totals to $38 billion.

 

2.        The PBoC also earns interest on its portfolio.  We are given zero information on the composition of the PBoC portfolio, but let’s assume (a safe assumption) that most of it is in government bonds.  That would add approximately 1% a quarter in interest income, or just under $16 billion for the first quarter of 2008.

 

Now for the part about which we are not sure but have some pretty good circumstantial evidence.  Headline reserve growth may have underestimated the amount of dollars which the PBoC was forced to buy for several reasons.  

 

In January, the PBoC hiked minimum required reserves by 0.5%, and they did so again in March.  This necessarily resulted in an increase in the amount banks had to deposit at the PBoC, which we can reasonably reliably estimate to be the RMB equivalent of $22 billion and $24 billion respectively. 

 

There is a strong circumstantial and market gossip that banks were “asked” to redenominate these deposits in dollars.  They would do so by effecting a series of accounting transactions.  As I understand it, the banks would sell RMB to the PBoC and purchase dollars, which would then be deposited as reserves, instead of RMB.  This accounting transaction would cause a net reduction in RMB assets on the banks’ balance sheets of the RMB equivalent of about $45 billion, and a net increase in dollar assets of $45 billion.  The banks now have more exposure to a declining dollar, unless they have a currency hedge with the PBoC.

 

The opposite occurs at the PBoC.  Their dollar assets decline by $45 billion.  Had this transaction not taken place, in other words, the PBoC’s headline reserve growth for the first quarter would have been $199 billion, not $154 billion.  Because the banks were forced, in effect, to take on $45 billion of the PBoC’s role, they saved the PBoC from being forced to record $45 billion more reserves, but they did not prevent the PBoC from buying these in the market.  In fact the act of redenominating had no impact on either the amount the PBoC needed to sterilize (although of course the reserve requirement hike did) or on the net amount of foreign currency inflow that had to be purchased by the PBoC.

 

Finally, and this all come from Logan Wright, there is very good reason to assume that the full transfer of $200 billion to the CIC was completed by March of this year, and he believes (for reasons which I prefer he explains, but which seem solid to me) that perhaps $95 billion of this transfer took place in 2008, probably in March.  Let me dump the full amount into March.

 

That leaves us with the following table:

 

	January	February	March	Total
Headline reserve growth	62	57	35	154
Trade surplus	20	9	14	42
FDI	11	7	9	27
Currency gains	10	10	18	38
Interest	5	5	5	16
Unexplained amount	16	27	(11)	31
Reserve hike	22	-	24	45
Adjusted reserve growth	83	57	59	199
Unexplained amount	38	27	12	76
Transfer to CIC			95	95
Adjusted reserve growth	83	57	154	294
Unexplained amount	38	27	107	171

 

To read this table, we start with official headline reserve growth at the top of the table.  After adjusting the things we know or can estimate reasonably, we get to an “unexplained” amount for each month.  This adds up to $31 billion for the quarter.  Notice that the “unexplained” amount for February is a negative number, suggesting that net other flows, including hot money, left China in deficit.  This is counterintuitive.

 

But not for long.  We then add back the amount we believed was taken out by the minimum reserve redenomination.  If we are right, the “unexplained” amount for every month is positive and the real growth in reserves was $199 billion for the first quarter.  The total “unexplained” amount is $76 billion.

 

I am a little bit nervous about the timing of the last assumption, although I am very comfortable that this did happen (the transfer of money from the PBoC to the CIC), but had there not been the transfer to the CIC, headline reserves should have higher, whether in 2007 or 2008.  Logan believes much of this occurred in 2008.

 

If he is right, actual net foreign currency inflows purchased by the PBoC during the first quarter of 2008 was not $154 billion, the headline number, nor even $199 billion, but perhaps as much as $294 billion.  Consequently the unexplained amount ranges anywhere from $31 billion to as much as $171 billion.  How much of this is hot money?  Who knows?  But it doesn’t need to be a very high fraction for it to be a very worrisome problem.  In fact I would guess that by now speculative money inflows (included those incorrectly recorded in the trade and FDI accounts) are so high that the trade surplus is less and less the main pump driving out-of-control money growth in China.  Speculative money is probably the main problem, and only a currency adjustment will be able to resolve this problem quickly enough.

 

By the way annual M2 growth in March declined to 16.3, from 18.9% in January and 17.1% in February.  This is being heralded nearly everywhere as an indication that the PBoC has been successful in its fight against monetary expansion, but I look at things a little differently.  To me this level of money growth is still much too high, especially given the volume issued of sterilization notes and the 1% reserve hike during the quarter.  If this is all they can achieve with so much effort, it is going to be a long and difficult fight.

 

SAT 12 APR

Food is becoming a global problem By Michael Pettis

Here is what Germany’s Speigel says in an article titled “Chaos spreads as food prices skyrocket”:

 

Food prices across the globe have been skyrocketing in recent years. Rice prices in Asia have spiked as has the price of bread in Egypt, milk products in Europe and pasta in Italy. The result has been unrest in a number of countries and many more concerned that a mass protest is but a price hike away.

 

Now, World Bank President Robert Zoellick has called on world leaders to act to ease the global food crisis. Zoellick urged the United States, the European Union, Japan and other developed countries to help plug a $500 million (€319 million) shortfall in the United Nations' World Food Program. In a speech given in Washington, D.C. on Wednesday, Zoellick said the money was urgently needed to meet emergency demands and warned that if politicians did not act now, "many more people will suffer and starve."

 

Unrest triggered by the higher food and fuel prices has been gaining steam across the globe in recent weeks. During a two-day riot in Egypt earlier this week, one person was killed. Cameroon has also seen street violence. In the Philippines, President Gloria Macapagal Arroyo warned on Tuesday that rice shortages were exacerbating political and social tensions in the country.

 

The tone of the article is a tad apocalyptical but the numbers are grim.  According to Speigel, the UN estimates that global food prices have risen 65% since 2002, with grain rising 42% and dairy products 80% last year alone. Of course I have already noted in this blog that rice prices in particular have risen dramatically and have caused problems in a number of Asian countries.

 

Although rising food prices should be good for farmers and so should help address China’s income inequalities, it is unclear the extent to which the authorities here are willing to allow food price increases to pass through to consumers, given their attempts to rein inflationary expectations in.  However if they do try to hold prices down, rising prices for food world-wide, especially in neighboring countries, will pose a problem to China even if it is largely food self-sufficient.  If it is more profitable to deliver rice and other products to neighboring countries than to sell it at home, it wouldn’t be long before we were to see at least part of China’s food production diverted to sales abroad, even if this were made illegal.  Long borders and widespread corruption will make it easy.

 

The sudden surge in concern about the impact of rising food prices on social stability is a little disconcerting.  With price stability across much of the world for so long, with the exception of the occasional crisis in a place like Argentina after the default in 2001, we have sort of forgotten how rising food prices can indeed cause a great deal of harm and social unrest.  This is certainly worth keeping an eye on, even in China.  Perhaps especially in China.

 

MON 14 APR

Have we begun the countdown to the maxi-revaluation? By Michael Pettis

Today’s China Daily reports a speech made over the weekend by a senior central bank advisor at the Boao Forum for Asia, in Hainan.  According to the article, Fan Gang, a member of the central bank's monetary policy committee and someone whose concern about hot money has often been cited in this blog, said China should remain wary of hot money inflows.  “China is seeing an even stronger capital inflow now, despite some nations suffering a credit crunch,” he said. 

 

A perhaps franker assessment was then provided by Zhu Baoliang, vice president of State Information Center, a research institution under the National Development and Reform Commission.  According to a China Daily article referencing the official Shanghai Securities News:

 

“More than $80 billion in hot money came into China in the first quarter, compared to the total hot money inflow for the whole of 2007 of around $120 billion and an average monthly amount of $10 billion (last year). So this year's hot money volume is three times last year's,” Zhu was quoted as saying.

 

The inflows in the first quarter have increased market liquidity, which in turn could put further upward pressure on inflation, he warned.  Because of this, the Chinese government must be cautious in allowing faster yuan appreciation, he said. While faster currency appreciation will help ease domestic inflation by dampening the price of imports, it will also cause higher hot money inflows speculating on the currency's rise.

 

In Saturday’s entry I tried to figure out what is happening to the hot money proxy as far as the most recent reserve numbers go, and although it is not always easy to understand given the opacity of the PBoC’s accounts and the various did-they-or-didn’t-they moves that may have affected the headline numbers, I think that the evidence is pretty strong that hot money inflows are coming in fast and furious.

 

I don’t know if Mr. Zhu’s $80 billion is correct – no one can really say how much hot money there is because most of it is necessarily hidden – but I am intrigued that whatever proxy he uses suggests that hot money inflows have tripled compared to last year.  That certainly fits in with my own intuition.

 

The existence and size of hot money inflows is not just a debate about monetary growth.  I believe it is the key determinant as to whether or not the PBoC will continue the current appreciation path or be forced into a maxi-revaluation.  Rapid but gradual appreciation of the currency will actually worsen the country’s financial imbalances if they cause such an upsurge in monetary inflows that the PBoC becomes totally helpless in controlling monetary growth.

 

Since the only effective way to stop these inflows would be to eliminate the cause of the inflows – the expectation of appreciation – if these inflows are so huge so as to be seriously destabilizing the PBoC will have to make the one-off jump that brings the currency into at least temporary balance.  The problem is that the longer they wait, the more monetary problems they store up and the more difficult the adjustment.

 

It is interesting that there seem to be a lot of comments circling around this point.  According to Mr. Zhu “Allowing the yuan to appreciate rapidly in a short period of time and then holding it stable would be very useful to restrain hot money.”  He also argued, according to China Daily, that the opportunity for using yuan appreciation to fight inflation will exist in China only in the first half of this year.

 

I am not sure what he means by the opportunity only existing in the first half of the year, but it is interesting that he favors a rapid appreciation followed by a peg, which is also my own favorite policy choice.  The difference between us, and it might not be a difference at all, depends on what he means by “appreciate rapidly in a short period of time.”  Certainly a maxi-revaluation could be included under that phrase.

 

On the other hand Zhou Xiaochuan, the PBoC’s governor, said from Washington yesterday that the PBoC still has room to raise interest rates rather than rely exclusively on RMB appreciation.  According to Bloomberg,

 

“China will do things according to our own economic situation,” as the nation isn't “highly dependent”' on the exchange rate for reaching the inflation target, Zhou said. “The anti-inflation policy is a combination of both quantitative measures and price measures.”

 

Don’t expect too much more appreciation, he seems to be saying, since we still have other tools with which to fight inflation.  I guess he has to say that, but I wonder if he is as worried as I think he should be. 

 

Meanwhile Liu Shiyu, the deputy governor of the People's Bank of China, said in Shanghai over the weekend something that I guess we already knew: CPI inflation for March, although not to be formally released until Thursday, is going to come in at 8.3%.  This means that annualized inflation for the first quarter of the year is 13%.   

 

I think this is just the beginning of a longer inflationary period in which declining food prices will be matched by rising non-food prices, as explained in my April 4 entry, but to be fair there are still a lot of economists, and still a majority, who disagree.  For example according to Shen Minggao, an economist at Citibank:  “Consumer inflation probably stayed high in March on costly food while non-food prices picked up pace. We continue to believe that the estimated 8 percent CPI rate in the first quarter will mark the peak of inflation this year.”  We’ll see.  A lot of bank economists are arguing that March, or perhaps April, will mark the inflationary peak, but I have to say I am very, very skeptical.  This is going to continue much longer, especially as hot money inflows have gotten much worse.

 

By the way I saw an interesting piece about the problem of surging rice prices in today’s Financial Times.  The article said that according to the Asian Development Bank food accounts for 40% of the Chinese consumption basket.  The National Bureau of Statistics of China reportedly has food comprising just over 33% of the CPI basket.  My quick-and-dirty calculation suggests that if we adjust the food component upward inflation is actually substantially higher than reported.  For example in March it wouldn’t be 8.3% – it would be closer to 9.6%.

 

TUE 15 APR

New loans exceeded the loan cap By Michael Pettis

The sudden spate of figures coming out over the past three days has meant that some of the things I like to discuss on this blog had to be pushed back a bit.  The most interesting of these things, for me, was the new lending numbers released late last week.

 

New loans in March totaled RMB 283 billion.  This was after February’s RMB 242 billion and January’s rather shocking RMB 804 billion jump in new loans.  The total for the first quarter, then, was RMB 1.33 trillion.

 

Since the loan cap for the first quarter was RMB 1.26 trillion, we have exceeded the cap by 5.5%.  This is not a huge miss given some of the other experiences we’ve had with loan caps, but it does show that the ferocious new loan caps proposed late last year are not as ferocious as all that.  The bad weather early in the year and the concerns about the impact of a US slowdown have made it easy for policy-makers to relax their overheating concerns slightly.

 

Is this justified?  I am not so sure that it is.  First of all it is hard to see much impact of a US slowdown given the still-strong growth in total exports.  It is true that US export growth has slowed markedly, but since this has more than fully been taken up by the growth in exports to Europe I would argue that the slowing US export growth has more to do with the weakness of the dollar against the euro than it did with reduced demand from the US, especially as the latest US trade numbers have shown a surprising increase in US imports recently.

 

Second, with China’s GDP growth for the first quarter of 2008 expected to come in at 10.6% (the data release is set for tomorrow, but we’ve had enough leaks to be pretty certain of both the GDP growth numbers and the inflation numbers), it is not easy to make the argument that global conditions have put a serious crimp on Chinese growth.  It seems to me we are still in overheating stage.

 

Still, I don’t think I am too concerned about their relaxing the loan caps.  I think the overheating is a monetary problem, not a lending problem.  The banks are only the medium though which excess money creation is converted into excess investment, and attempts to constrain their role are likely only to push them out of the intermediation loop.  That would, in my opinion, reduce PBoC control even more.  As long as this thing is going gangbusters we might as well have it happen via the banking system – at least the PBoC has some control there and the banking numbers are reasonably more transparent, although of course this does increase the risk of a banking sector crisis, something not to be passed over glibly.

 

On a different note, yesterday Xinhua had an interesting article on new developments in the corporate bond market.  According to the article:

 

Chinese companies will no longer need the central bank's approval when issuing short-term bonds on the inter-bank market amidst government efforts to boost direct financing and reduce bank loan risks.

The People's Bank of China (PBOC) announced non-financial companies could issue bonds with maturities of less than one year on the inter-bank market without its approval from April 15.  Instead, they would only need to register at the National Association of Financial Market Institutional Investors set up in September, the PBOC said in a statement issued late on Saturday.

 

It said other negotiable notes “with a certain maturity” issued by non-financial companies on the inter-bank bond market wouldn't need administrative examination and approval either. Nor would future innovative financing tools on the market.  China has vowed to develop its capital market and broaden direct financing channels to curb enterprises’ heavy reliance on bank credit.

 

Anything that speeds up the development of the corporate bond market is good for China in the medium term because, as things currently stand, Chinese companies rely too heavily on banks for their financing needs, and that keeps the economy hostage to adverse developments in the banking system. Of course in the near term making it easier to issue only short-term bonds does come with a risk.  Bond financing is much cheaper than loan financing, and the main thing that has kept corporations from turning more aggressively to the bond market has been the difficulty in getting approval.  By relaxing the approval process for issuing short-term bonds I suspect we may quickly see a significant increase in issuance.

 

If this increase is matched by a reduction in short-term bank loans, it won’t matter much, but if it comes at the expense of a shortening of debt maturities on corporate balance sheets, it will almost certainly increase systemic risk.  My assistant Oliver Shang Ning sent me a breakdown of debt levels and debt maturities for the non-financial corporate sector last week.  I haven’t had a chance to give it more than a cursory glance, but it seems to me that Chinese corporations are pretty highly levered with much of the debt in the form of short term debt.  They probably don’t need to increase their short-term debt levels.

 

But to return to more interesting (in the near term) topics, tomorrow at 2:30 CPI numbers come out.  We pretty much already know that headline CPI inflation is going to be 8.3%.  Far more interesting will be the breakdown between food and non-food inflation.

 

WED 16 APR

Non-food inflation is rising By Michael Pettis

I am traveling in Shanghai today so it is not easy for me to post a long entry.  Of course a lot of interesting numbers were released today.  The only comment I have time to make today is on the CPI numbers.

 

As expected CPI inflation came in at 8.3% year on year.  This implies that prices declined by about 0.7% during the month of March.  It also implies that inflation for the first quarter of 2008 is running at 12.9%.

 

To me the most significant thing was the high level of food inflation – 21% – combined with the rising level of non-food inflation.  I calculate that in January non-food inflation was 1.6%, it rose to 1.8% in February and to 2.2% in March.

 

This rising inflation in the non-food sector, even though it is still under the PBoC target of 3%, is completely inconsistent with the argument that China is only experiencing a temporary food-supply problem.  Food prices rising at 21% annually should put brutal downward price pressure on non-food items if the inflation target is credible – that is if PBoC monetary policies are consistent with the target.

 

The fact that not only is there inflation in the non-food sector, but there is accelerating inflation, indicates to me that the inflation target is not remotely credible.  Another one or two months of rising non-food inflation will be enough, I think, to settle the matter once and for all.

THU 17 APR

Minimum reserve requirements jump to 16% By Michael Pettis

“Now, we not only have to prevent a sharp downturn of the economy, but also a rebound in investment,” Li Xiaochao, spokesperson for the National Bureau of Statistics, said in his comments yesterday.  He also said in the same release that “the top concern is still inflation.”

 

He’s right.  Not only were the inflation numbers pretty grim, as I see them, but fixed asset investment is up pretty substantially to RMB 2.185 trillion, for a 24.6% increase year on year, versus an already-high 23.7% increase over the same period one year ago.  Yesterday the State Council, which is chaired by Premier Wen, released a statement in which it said: "We need to closely watch the latest development of the economic situation, and strike a balance between promoting economic growth and curbing inflation.”

 

As regular readers know I am skeptical about the availability of policy tools that will permit a striking of this balance.  I think we have already passed the point of no return on inflation and monetary growth, and by now the only way to rein these in will almost certainly involve sacrificing employment in the short term.  The longer they wait, the greater will the needed sacrifice be.

 

Given attempts to cool things down what explains the jump in investment?  Credit Suisse says it is a new round of local government-driven infrastructure investment, which makes sense given that typically every five years, when the new leadership takes up their positions, their first actions tend to involve a significant jump in spending.  I am also hearing that some of the hot money inflow is showing up in the informal banking sector and being lent out.  I noted, but did not comment on, an article in the South China Morning Post five days ago that was titled “SMEs turn to underground lenders for cash.”  According to the article:

 

Beijing’s credit-tightening policy could have sent some cash-strapped small and medium-sized enterprises (SMEs) to seek costly funding from alternative financing channels - the underground.

 

“If their loan demand cannot be satisfied by the banking sector, companies will look to the non-banking financial sub-sector for funding,” said David Kiang, a vice-president for international corporate banking at Shenzhen Ping An Bank, a subsidiary of Ping An Insurance. Mr Kiang added that some hard-pressed businesses might have borrowed from mainland pawn shops, which lend sums against collaterals at high funding costs just as Hong Kong's money-lenders do.

 

…Beijing's policy to limit banks' loan growth also makes it harder for SMEs to borrow. Big banks traditionally prefer to lend to larger firms and have become even more selective now that the lending cap is in place.

 

This isn’t surprising at all and in fact several times over the past few months I have speculated that the informal banking sector would be taking up the lending slack.  I wish I knew of some way to track the sector.

 

At any rate, and as everyone knows (they slipped it in after I finished yesterday’s blog entry), the PBoC raised the minimum reserve requirement rate again, by 0.50% to 16%.  I expect that they are going to do this several more times this year.  Since most other “market-based” policies don’t seem to work or may even exacerbate weakness in the banking system or increase monetary inflows, this is likely to be one of their favorite solutions, although of course raising the minimum reserve does strain banking sector profitability and I think banks desperately need profits with which to help dig them out of their non-performing hole.  There are no easy solutions – every thing they give with one hand they take away with the other.

 

But I am not sure the raising the minimum reserve requirements will anyway make that much of a difference.  Each reserve hike drains about $20-25 billion from the system, but with currency reserves growing by about $50-90 billion a month so far this year (the wide range exists because we are not sure exactly by how much headline reserve growth needs to be adjusted to account for the full impact of net inflows, as I explained in my April 12 entry), we’re going to need a much more aggressive stance to reduce underlying liquidity, and with so much worry about excess slowing, I don’t expect we’ll get that level of aggressiveness.

 

By the way in today’s Wall Street Journal Asia I have an Op-Ed piece explaining why I think the low but rising inflation in the non-food part of the Chinese CPI is so worrying.  The basic argument is that if food prices were rising so quickly because of a supply problem, the fact of their rising would put so much downward pressure on the non-food sector that we would see severe deflation, or at least disinflation, in non-food prices.

 

In fact we are seeing low, but rising, inflation, which is inconsistent with the idea that this is just a food-supply problem.  It suggests that inflation is caused by excess money, and that the sudden partly coincidental jump in food prices has simply absorbed most of the inflationary pressure, thus keeping it from showing up in the non-food sector – until food prices stop rising.  You can find the full article at:

http://online.wsj.com/article/SB120838835562221079.html?mod=opinion_main_commentaries

 

FRI 18 APR

The RMB and the euro By Michael Pettis

Two days ago I was in Shanghai speaking at a conference organized by a French bank.  For some reason I was included in the panel discussing opportunities for Chinese investors in the euro market.

 

I suspect I was not the right person to have on that panel because my position on the subject is not likely to lead to a stampede of Chinese investments into euro-denominated products.  First of all, I don’t think Chinese investors should buy any foreign currency product until the RMB issue has been resolved.  With the expected appreciation of the RMB as high as it is, only extremely high-yielding, very risky foreign-currency-denominated assets can be expected to match the returns one can get by simply depositing RMB in a bank account.  Why take the risk?

 

Second, I think the euro is overvalued relative to the dollar, and although we may see more dollar weakness in the short term, my own bet is that the euro will strengthen in the one- or two-year horizon as Europe’s trade deficit continues to swell.  Lombard Street Research, a London-based research group and one of my favorites, expects the dollar’s fall to be more of a bungee jump, and they expect the rebound will occur once the markets see the European trade deficit as unsustainable and the euro’s position as precarious.  I agree.

 

Finally, and this is really a much longer-term issue, I am still very skeptical about the survivability of the euro.  It seems to me that the strains in the euro zone – especially in countries like Spain, where monetary policy is much too loose, and Italy, where sovereign debt levels are rapidly becoming unsustainable – will put serious pressure on the euro once we end the current liquidity cycle that we have experienced over the past 15-20 year.

 

I say this because we have some disturbing historical precedence.  Currency unions among regions that don’t fulfill the Mundellian rules (including high degrees of capital and labor mobility and free trade) aren’t new.  There are plenty of previous examples, but my reading of their histories is that when they are successful they are successful largely during the expansive period of a global liquidity cycle.  I cannot think of any that didn’t hit the skids when the liquidity cycle ended.  There are many reason why I think this makes sense, and perhaps in some future entry I will discuss why, but suffice it to say that as weaker eastern European countries with their more fragile balance sheets enter the euro the likelihood of a global liquidity contraction playing havoc with the members of the union rises.  We still haven’t been seriously tested, and it is only after a really difficult test that we will be able to say with some confidence that the euro experiment has been a success.

 

Still, in spite of my nay-saying there are some China-related things that are relevant to a discussion of the euro and which I brought up in the conference.  The main point, made by many other much smarter people besides me, is that the strength of the euro and other related currencies is significantly affected by the Chinese currency regime (actually by a number of dollar-related currency regimes of which China is the bellwether) because the euro’s strength was caused by the pressure for the dollar to devalue against the currencies of its trading partners, and as long as the RMB and other related currencies were pegged or managed, the full brunt of the adjustment had to occur in currencies where there was no massive central bank intervention – e.g. the euro.

 

If the US trade deficit is unsustainable, currencies have to realign so that the deficit becomes more manageable, and probably the healthiest way for that to happen is for the dollar to realign against the largest trade surplus countries – after all if trade surpluses do not decline, trade deficits cannot decline either.  That means that the brunt of dollar weakness should have occurred against China, Japan, the OPEC countries and other Asian countries who peg to the dollar, to the extent that their trade surpluses decline.  Only then can we see a reduction in the US trade deficit that doesn’t occur simply by shifting it elsewhere.

 

This hasn’t been allowed to happen.  The US trade deficit is not disappearing, it is simply being shifted to Europe.  I don’t think that can last very long.