Asmore’s Dehn: US China imbalances building up

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Jan Dehn, head of Research at Ashmore discusses the imbalance between China and the US, with China racking up another record trade surplus – this time $60bn – just weeks after the US recorded a trade deficit of $47bn.

Why the imbalance? Because the US has replaced decades of debt-fuelled stimulus with years of hyper-easing by the Fed. This is keeping spending going, but it is against the backdrop of low productivity and still enormous debt burdens that will make it hard to materially tighten policies. By contrast, China’s demand for imports is waning because the country is engaging so seriously in reforms. The continued accumulation of trade imbalances is unsustainable and will end in the time-honoured fashion – with inflation and currency realignments

China’s January trade surplus of $60bn was the largest on record and occurred despite weaker than expected exports. The main driver of the strong trade balance number was therefore weaker imports.  The recent decline in oil prices was an important contributor and Chinese New Year effects may also be playing a part, but interest rate liberalisation and the rapid pace of other structural reforms are almost certainly the most important reasons for the softer import number. Experience from other countries engaged in serious structural reforms point to a phenomenon that economists call ‘crossing the desert’ – a phase of slower domestic demand during the reforms, which then give way to stronger growth after the adjustment (stronger than would have been possible without the reforms).

China has the means to support the economy during the adjustment – the PBOC‘s decision to cut reserve requirements for financial sector institutions by 50bps last week is an example of this capacity for support. Technically, of course, the larger than expected trade surplus should also result in a stronger than expected real GDP growth number as lower imports drive net exports higher.

It is important to place the Chinese trade surplus in a global context. The Chinese trade surplus contrasts with a US trade deficit of $47bn in December. Clearly, the global imbalances remain intact. The US ultimately needs to reduce demand to bring it more closely into line with its lower level of productivity and higher debt burdens, but is instead continuing to stimulate demand with extremely easy monetary policies, while not undertaking any productivity enhancing reforms. On the other hand, China with its already large FX reserves continues to build external surpluses. The global imbalances are unsustainable. In the absence of serious supply-side reforms, the US will ultimately end up with an inflation problem due to the constant stimulus of aggregate demand, which is of course why China is reforming so much – China knows that in just a few years it will have to find a way to grow with a much stronger currency as the Dollar is debased by inflation. In the meantime, we believe that investors can profit from China’s reform-induced slowdown and declining inflation pressures by investing in Chinese government bonds.

China’s breath taking pace of reform will put the country in a strong position to grow in the future while countries that are not reforming with such determination – or not at all as is the case in most developed economies – will struggle.

Talking of reforms, the Chinese government announced proposals to further decentralise spending decisions from central to local governments. This reform will not only increase the quality of fiscal spending, but also help to raise consumption levels in China. The reform re-defines the specific roles of central and local governments by giving local governments more room to allocate spending in accordance with their own priorities and increases overall the level of spending that local governments can exclusively manage to 60% of total central government transfers. This is likely to be accompanied by another reform to increase auditing of local government spending. Experience from many other countries shows that priorities for spending at local and national level often differ substantially and often results in misallocation of resources relative to intended budget destinations and moral hazard issues. Under the new framework, local government administrations will have greater flexibility to establish pension and medical healthcare provision. This is particularly critical to raising consumption levels in China.

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