How Big is China?

China-bashing is back in fashion in Washington and Brussels.  The U.S. Congress is demanding that China re-value its currency to correct what is perceived as a trade imbalance.  The financial press has called this, delightfully, a product of “The collective brain deficit trust, otherwise known as the US Congress.” Europe is also growing increasingly impatient with the Chinese propensity to undervalue its currency – and more broadly with the Asian tendency to do the same.  With massive imbalances in the English-speaking world, and Asian currencies effectively pegged, the euro has been left to pick up the slack.  Logically, this leaves exporters in Europe unhappy. The U.S. current account problem is not, of course, China’s fault.  The Bush Administration, aided and abetted by local governments and private households, has been fiscally profligate.  Combined with dismally low savings rates, this means the U.S. ran a current account deficit of 6.5 percent of national income, according to the IMF, in 2005 and 2006. Thankfully, this is projected to fall to “only” a deficit of only 6.1 percent in 2007.

China’s exchange rate policy mirrors, in some ways, the growth path followed by German from 1947 through 1970.  Germany built its economic miracle on a strong export industry supported by an undervalued D-mark and by the recycling of its surplus through foreign investment and aid.  (See Hetzel for more on this.)

So… if China is following a path marked by Germany, what exactly is the problem? To put it bluntly, the problem is the dragon in the middle of the room.  China’s economy has grown, to be hyperbolic, to epic proportions.  Before I discuss numbers, I should briefly review the concept of purchasing power parity and the Balassa-Samuelson effect.  Because wages are low, service prices tend to be low in developing countries.  This translates into a general low price for non-traded goods, so that official exchange rates understate the actual value (and hence size) of the domestic side of developing economies.  Various efforts are made to adjust for this (i.e. to make values reflect relative prices) when we compare per-capita incomes.  This means that the size of China’s economy is underestimated when we use world prices.  This is even before we add the issue of an undervalued exchange rate.  This point is illustrated in the figure below.





In the figure, the left-hand axis plots China’s GDP, while the right-hand axis plots China’s current account surplus as a percent of GDP.  The first set of numbers is at nominal prices, and the second reflects adjustment of China’s GDP to reflect differences in prices and purchasing power (known as a PPP adjustment).  What emerges is that while China’s trade surplus, as a share of GDP, is huge at official exchange rates, it is actually quite reasonable given the actual size of the Chinese economy.  Indeed, if we valued the basket of China’s domestic (i.e. non-traded) goods and services at U.S. prices, the Chinese economy is roughly 81% the size of the U.S. economy, while the trade surplus is only 2.7 percent, rather than the 10.0 percent estimated by the IMF at official exchange rates.  A consequence of China’s current exchange rate policy is to overstates its trade surplus, and understate the size of the underlying domestic economy. Indeed across Asia we tend to understate the size of the regional economies and overstate trade relative to domestic activity for the same reason. You can make these, and similar calculations, yourself with data from the IMF's World Economic Outlook.

In the interest of overkill and overstatement, the second figure compares Germany, China, and the U.S. in 1980 and 2007.  Again, we are looking at GDP and the current account surplus, adjusted for PPP.  What this shows is that, valued at OECD prices, China’s economy has surged past Germany, and is now over 4 times as big as Germany’s.  This contrasts sharply with unadjusted data. At official exchange rates and without adjusting for China’s price levels, the two economies are roughly the same size.  Also striking is the size of the relative trade surpluses.  The IMF projects that Germany will have a current account surplus of 5.3 percent (at official exchange rates), which is equal to 6.1 percent of PPP-adjusted GDP.  China’s trade surplus, on the same basis, is 2.1 percent of PPP-adjusted GDP.  In terms of the share of goods and services produced and priced on the same basis, Germany’s current account surplus is 3 times larger than China’s on a share basis.  Yet Congress is not bashing the euro zone.  Congressional moves attacking currency manipulators (i.e. Baucus-Grassley-Schumer-Graham)  target Asia, not Europe.

Given the relative under- and over-valuation of Asian and European currencies, and the relative size of current accounts relative to actual GDP, one is left a bit bemused.  China is following a macroeconomic growth path marked out by Germany, and for this it is being condemned.  At the same time, U.S. imbalances are being pegged on everybody but the U.S. itself.  And no one is talking about the real reason why China’s surpluses have such a big impact on the world economy.  Quite simply – China has grown huge, and this is masked by current exchange rate policy, combined with a healthy does of Balassa-Samuelson effects.  For a long time, as the world’s biggest kid on the block, U.S. imbalances have had a major impact on global capital markets, sometimes sucking capital in from smaller countries and regions.  China (abetted by Japan) appears to be softening this effect somewhat.  Do we really want this to end abruptly? Be careful what you wish for, as you may actually get it.

Further reading

[1] Be careful what you wish for,” John Mauldin, FXstreet.com, 16 June 2007.

[2] German Monetary History in the Second Half of the Twentieth Century: From the Deutsche Mark to the Euro,” R.L. Hetzel, Federal Reserve Bank of Richmond Economic Quarterly Volume 88/2 Spring 2002: 29-64.

[3] Baucus-Grassley-Schumer-Graham,” International Political Economy Zone:  Tales of Power, Money, and Occasional Violence, Wednesday June 13 2007.

[4] Balassa-Samuelson Effect," Wikipedia.

[5] The IMF's World Economic Outlook database.

[6] The International Comparison Program.

[7] " France Raises Prospect of New Bra Wars," The Scotsman, 19 Jun 2007.

The Trade Deficit and the Politics of Misdirection

The political class in Washington is becoming increasingly agitated about the U.S. trade deficit... again. The reaction is to blame Europe, Japan, and China. We have House of Representatives Speaker Nancy Pelosi and her team saying, "We ask you again to join us and develop a meaningful action plan that addresses the burgeoning deficit" in a letter to President Bush. We have blogs trolling through past episodes of U.S. deficit panic. We have been here before. Well, maybe not here, but in a frighteningly parallel universe version of here, with ballooning trade deficits, large budget deficits, and general panic in Washington. Yet past episodes usually involved a high dollar making imports cheaper and exports uncompetitive. Real U.S. exports are actually up 25 percent since 2001. As a percent of GDP, they are also up from 10.2 percent to 11.1 percent of GDP since 2001. In contrast, when the trade deficit surged between 1991 and 1994, the dollar was up 22 percent. At the moment it is down by a comparable amount between 2001 and 2006. While things are similar, superficially, to recent past deficit scares, they are also different in important ways.

The situation is at once deceptively simple, and yet quite complex. From national income identities, a growing deficit "squeezes" GDP. Throw in some mindless accounting, and you can argue that it costs jobs. Throw in a video camera as well, and some air time on CNN, and you have the Lou Dobbs show. (No I am not going to link to mind candy. Google it yourself). Yet things are not so simple. The U.S. has an unsustainably low national savings rate. The IMF projects that the U.S. may borrow 7 percent of GDP in 2007. In part, (and technically by definition) this is what drives the growth of the trade deficit. Congress should be asking itself if, as policy, the U.S. should feel comfortable borrowing 7 percent of GDP, given that it will need to borrow even more (publicly or privately) to fund surging retirement and health care benefits in the immediate future.

It is also informative to work the numbers a bit, and deconstruct the surging deficit. An obvious candidate is inflation. If we look at the deficit in constant dollars (you can download these from BEA in 2000 dollars), the trade deficit since the Bush White House took over in 2001 has grown by one-third. Another 10 percent of the nominal growth is due to a general increase in U.S. prices. So roughly one-quarter of the growth is simply inflation. Another force driving the nominal deficit growth is linked to the drop in the dollar. On a trade-weighted basis, the Federal Reserve's nominal broad dollar index has fallen by about 14 percent since 2001. This is despite the broad Asian peg to the U.S. dollar. Against the euro, the dollar has lost more than 35 percent. On this basis, in foreign currency terms, another third of the surge in the deficit is clearly linked to exchange rate changes. The same imports cost more. The ironic thing here is that the move in the dollar -- down -- should be helping the trade deficit, all other things being equal. However (and this is the proof that we have not really been here before despite the déjà vu) the currency is being driven this time by the same forces driving the trade deficit itself. The U.S. wants to borrow increasingly more money. There apparently is not sufficient growth in the supply of credit from our collective foreign bankers. So.... mathematically something has to budge. Since the U.S. borrowing spree has refused to budge, the solution in the market has been to drive down the dollar, so that the same foreign currency-denominated credit goes farther in dollar terms. You can borrow more dollars when they are worth less. The remaining growth in the deficit, about one-third of the total nominal growth, can be linked to rising oil prices and growing U.S. demand for foreign credit.

So, in a roundabout way, I agree with the Democratic leadership of the U.S. Congress. Something needs to be done. That something includes a more economically literate discussion of the issues. The American public does not need populist economic rhetoric. The growth in the deficit is large, but not as large as advertised in the current round of speeches, and not for the reasons cited. In real terms, most of the growth has been driven by the surge in U.S. collective borrowing, combined with high oil prices. Any real policy debate should therefore start with U.S. borrowing (federal, state and local, and private) and the reasons for rising oil import bills. Beating up on China, the EU, and Japan is a sideshow at best -- populist rhetoric. The Euro has appreciated by roughly 50 percent against the dollar (the flip side of the dollar falling by 35%) since 2001. What are they supposed to do exactly? The Asian peg is a problem, but the U.S. needs to be very careful how it unwraps that particularly complex web of excess global liquidity (from Japan's implicit support of the massive Yen carry trade) and U.S. need for more and more buyers in domestic bond markets. Discussion on budget (not trade) deficits and energy policy would be a constructive response to the deficit. Beating up on trading partners is not.