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.

Deficits redux

A short follow-up on my earlier posting,Deficits and ... more deficits. The "reserved central bankers" in the U.S. are now using words like "frightening" and "crisis." What they said this week:

We now have Janet Yellen, the San Franciso Fed President, on the record saying the long-term budget picture ''frightens me... We'll be looking at budget deficits that will make us wish for the level that we have now...''

Federal Reserve Chairman Ben S. Bernanke said the U.S. government may face a ''fiscal crisis'' in the coming decades.

from Reuter's,''Federal Reserve Chairman Ben Bernanke on Thursday told U.S. lawmakers that a review of U.S. tax code would be a good idea. 'I think the conventional wisdom among economists is that tax cuts don't necessarily pay for themselves,' Bernanke told the Senate Budget Committee."

On top of this, it seems that U.S. investors may be catching on, and shifting their portfolios abroad. ''U.S. investors send their cash packing.''

Deficits and ... more deficits

The economics editorial debate in the U.S. has been focused lately on the Federal budget deficit. The U.S. now owes roughly $8.6 trillion in public debt. This continues to grow. In 2005, the Federal budget deficit was $319 billion. This dropped to $248 billion for the fiscal year ending September 2006. The projected deficit for 2007 is $423 billion. This is the apart from the additional accumulation of debt by state and local governments. (According to the Federal Reserve, state and local debt amounted to another $1.85 trillion in 2005). And of course, households also continue to accumulate debt. Much of this debt accumulation is funded by foreigners. Indeed, the exposure of foreign investors to U.S. debt and equity markets is now so large that they simply have to be getting nervous. A recent IMF working paper ('How Might a Disorderly Resolution of Global Imbalances Affect Global Wealth?' Francis E. Warnock; IMF Working Paper 06/170, July 1, 2006) examines just what this exposure means. By his estimates, a 10% decline in equity and bond markets, combined with a 10% drop in the dollar, would translate into a loss in foreign wealth equal to roughly 5% of foreign GDP. In the case of Canada, this is almost 6.25 percent of GDP. In contrast, in 1994 this would have been 2 percent. While attention in the U.S. has been focused on the budget deficit, tied to this debate is the ability of the U.S. to continue to finance its spending with foreign funds. Indeed, while the U.S. is borrowing more and more from abroad as a share of GDP, the prospects are not good. The bill for the retiring baby boomers has not yet come due. When social security payments and Medicaid and Medicare explode, things will get very interesting fiscally. Social security may be realtively well financed over the long term. Combined with the costs of Medicaid, Medicare, and the occasional optional war, however, the accounts are not so neat and tidy.

In retrospect, one gets the feeling that in the Clinton years, a (relatively) good faith effort was made by the baby boom generation to put the fiscal house in order for their looming retirement oblgations. This has all been squandered, of course, and there is no going back. Surprisingly, it looks like a number of editorial writers who have attacked Bush in the past for fiscal irresponsibility are now, for various reasons, instead rationalizing a shift in expenditures rather than restoring fiscal order. Paul Krugman ("Democrats and the Deficit," December 22 2006), for example, apparently does not now believe that the electorate is willing or able to support a fiscally responsible government. 'Rubinomics made sense in terms of pure economics, [but] it failed to take account of the ugly realities of contemporary American politics...'. If we are going to have deficits anyway, the logic runs, lets at least spend the money right.

The elephant in the room is the foreign lender. All of this hinges on the assumption that the Japanese will continue to print yen, the Chinese will continue to build up mountains of dollars, and the Europeans will continue to pour their pension savings into the U.S. debt and equities market. Can we really assume this will continue? If not, the budget pundits and apparatchiks are all in for a rude shock. We are in uncharted territory. According to the IMF, the U.S. current account deficit in 2006 was 6.6 percent of GDP. They project that this will be 6.9 percent of GDP in 2007. At this rate, foreign debt is accumulating faster than the underlying growth rate of the U.S. economy. By the standards of the last 100 years, these trends are simply unprecedented. Most likely, they are also unsustainable. They have implications for the dollar, U.S. asset prices, and "long-term" adjustments to the U.S. Fiscal balance that may not be so far away after all, if and when foreign investors change their collective mind. (See the CRS report 'Is the U.S. Current Account Deficit Sustainable?' for an overview of studies on how this might all play out.)

At the same time, with Krugman changing his tune, there has been a bit of bashing going on. Some examples can be found at the Marginal Revolution site. One post asserts that "Democrats resent me getting money that rightfully belongs to them..." Maybe Krugman is right that, in the current climate, serious discussion about fiscal responsibilty is not possible. To be honest, I resent everybody spending money that belongs to my kids (and grandkids for that matter...) Tax refunds in the face of continued borrowing does not mean no one will be paying the bill. I once tried to explain to my (then 12 year old) daughter how every American owes $28 thousand in public debt. She was not pleased.

© JFF & Intereconomics, LLC 2006