The German and Chinese trade surpluses

April 5, 2017

As a follow up piece to my posting about the dangerously delusional views of Mr Dijsselbloem I would like to point readers to a recent article by Michael Pettis who is one of my favourite economists. Pettis is a professor of finance at the Guanghua School of Management at Peking University in Beijing who has written a great deal about the Chinese economy and about trade imbalances in general (check out his books here).

The Pettis article I want to draw you attention to is on the Bloomberg site and is entitled “What’s Really Driving the Trade Deficit With China”. Generally his view is that when it comes to explaining trade imbalances there is too much attention paid to currency and exchange rate mechanisms and not enough focus on the underlying internal national imbalances, such as excess savings, that drive trade surpluses.

The entire article is worth a read. This what Pettis has to say about Germany.

Take Germany, for example. After a decade of trade deficits and high unemployment, worried leaders in Berlin implemented labor reforms in 2003-05 whose main effect was to weaken wage growth. As unemployment dropped and business profits surged, the reforms also shrunk the share of national income allocated to ordinary households, driving down the consumption share as well.

German businesses, blessed with higher profits, responded unhelpfully. They paid down debt instead of investing the profits, increasing the share of national income devoted to savings. As the growing gap between German savings and investment soon became among the largest in history, so did the German trade surplus. German banks exported the excess savings into other European countries, no longer protected by the interest-rate and currency adjustments proscribed under the rules of the euro. By 2009, after insolvency prevented one European country after another from absorbing any more of the German tsunami of capital outflows, these shifted to countries outside Europe.

On the issue of China and possible Trump tariffs he has this to say:

While the experiences of China and Japan may seem different on the surface, they were broadly similar in impact. China, for example, severely repressed interest rates in order to boost growth. This simultaneously reduced the household share of Chinese GDP to among the lowest ever recorded and raised Chinese savings to among the highest — so high that, even with the fastest-rising investment in the world, China still needed large trade surpluses to make up for weak domestic demand.

What happens next is the most confusing part for economists who don’t understand how trade has changed. When new capital pours into advanced economies that have always had easy access to investment — such as the U.S. and southern Europe — it doesn’t boost investment further. Instead it automatically causes savings to contract.

There are many ways this can happen. Capital inflows might raise the real exchange rate, which reduces savings by increasing household purchasing power. Inflows can also lower interest rates and weaken credit standards, both of which encourage high-flying households to fund consumption binges. They can set off wealth effects, as foreign money pours into real estate and leaves households suddenly feeling richer. They can raise unemployment, forcing workers to dig into savings.

These automatic adjustments, and many others, force down savings rates in the capital-receiving countries. With its deep and flexible capital markets and dominant reserve currency status, the U.S. is especially vulnerable. It is the only country able to absorb large amounts of foreign capital, currently taking in nearly half of the world’s excess savings.

Other Bloomberg articles by Michael pettis that are worth a look include:

Party Will Pay the Price for China’s Rebalancing

and

Debate: Can China Survive Trump?

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