Exchange Rates

Fed Governor Lael Brainard’s speech on central bank coordination last week was quite interesting—I think it should be read for far more than a signal on when the Fed is likely to next raise the policy rate. For one, Brainard argues that the ECB (and BoJ’s) asset purchases have had an impact on global yields. Makes sense. The ECB and BoJ are both buying more than their respective governments are issuing, so they are reducing the net supply of eurozone and Japanese government bonds on the market. That forces bond investors into other assets—be it short-term deposits at the ECB, bank bonds in Europe, or U.S. bonds of various stripes. That though wasn’t the central banking orthodoxy a few years ago. The spillover of U.S. asset purchases onto say European government bond yields was not apparent back when the U.S. was doing QE. In fact, QE2 generally coincided with generally rising eurozone government bond yields. In part because the eurozone was experiencing its own version of a self-created government funding crisis, as the creation of the euro meant that countries that previously issued bonds in their own currency were now issuing bonds in the ECB’s currency so to speak. And in part because QE2 coincided with a large U.S. fiscal deficit—it reduced the new supply of Treasuries investors needed to absorb, but it didn’t on net remove supply from the market.* But the really interesting bit isn’t the technical argument about global spillovers from asset purchases. It is the hint—at least in my reading—that the Fed and the ECB should pursue different tightening strategies. Consider a simplified global economy that constitutes three blocks. Two blocks have independent monetary policies and let their currencies float, and both have two central bank policy instruments—the policy rate, and the balance sheet. And the third block pegs, more or less, to one of the other blocks. The block that is now in a tightening cycle has a current account deficit of around 3% of GDP (and a sizeable net external debt position, so an underlying stock imbalance too). The block in an easing cycle (for now) has a current account surplus of around 3% of its GDP (a bit more actually). The block that pegs has a current account surplus of around 3% of GDP (after adjusting for some, umm, irregularities in its trade data) and pegs to the currency of the deficit country. The three blocks are obviously the U.S., the eurozone, and China. This model leaves a lot out. Japan and the newly-industrialized-economies (NIEs) combined have a current account surplus of well over 5% of their combined GDP. And the U.S. NAFTA partners all have sizeable current account deficits too. Brainard postulates that tightening through increasing the policy rate has a bigger impact on the exchange rate than tightening through balance sheet reduction. And thus the choice of central bank policy instrument can have an impact on net exports, and ultimately the equilibrium current account deficit. If I read her comments correctly, this argues for putting a priority in the U.S. on balance sheet reduction rather than raising the policy rate. That is because the dollar is already strong, and already distorting (in my view) the composition of U.S. output.I cannot find evidence to support McKinsey’s argument that a combination of robots (automation), cheap natural gas, and rising wages in emerging markets are going to reduce the U.S. trade deficit in manufactures at current levels of the dollar. Rather the contrary.** At current levels of the dollar, the U.S. trade deficit in sophisticated “capital goods” is actually rising. Basically, if given a choice, a country with a large existing trade deficit should choose to tighten its monetary policy in the way that puts the least pressure on the dollar, and the least pressure on the tradables sector. Interestingly, the opposite holds true for the central bank of a large surplus region. It should choose to tighten through raising the policy rate rather than through balance sheet reduction. That would help bring the economy into better external balance. It, in Europe, also probably has some positive financial stability spillovers. The nightmare scenario that reverses the eurozone’s current positive momentum is a blowout in Italian yields (see The General Theorist). And that risk would rise if the ECB is selling its Italian government bond (BTP) portfolio at the same time as regulatory efforts at “risk reduction” force the Italian banks to diversify their own government bond portfolio. ECB balance sheet expansion has expanded the supply of “safe” euro area assets while taking both duration and sovereign credit risk out of the market. An ECB that tightens through rates and a Fed that relies on balance sheet roll off, in theory, would work together to in effect weaken the dollar and reduce the U.S. trade deficit and European surplus. That at least is how I read this paragraph in Brainard’s speech: “Let's turn to the case in which the two central banks choose to rely on different policy tools. In this case, one country responds to the positive shock by hiking its policy rate to reduce output to its initial level, while the second country responds by shrinking its balance sheet. The country that relies on the policy rate to make the adjustment experiences an appreciation in the exchange rate, a deterioration in net exports and some expansion of domestic demand, while the country that chooses to rely solely on the balance sheet for tightening experiences a depreciation of its exchange rate and an increase in net exports. Thus, while both countries achieve their domestic stabilization objectives, whether the requisite policy tightening occurs through increases in policy rates or reductions in the balance sheet matters for the composition of demand, the external balance, and the exchange rate.” A weaker dollar would also make it much easier for the third block, China, to avoid a big depreciation that would raise its surplus. China now seems to manage against the dollar, more or less (though officially it manages with reference to a basket). It appears to have successfully carried out a modest controlled depreciation after the dollar’s 2014 rise—though the process itself wasn’t totally smooth. The yuan is now stable, in part because stability (against the dollar) creates expectations of stability and thus reduces outflow pressures, and contributes to stability (in reserves). And in part because China reversed its premature financial account liberalization. Indeed, if China decides it wants to manage with respect to a basket for real, the yuan should appreciate against a depreciating dollar. Which would help the PBOC convince the market (and more importantly Chinese residents) that the yuan isn’t a one way bet, and also help keep the U.S. trade deficit from rising—China’s export volume growth in the second quarter was extremely strong, so I suspect China’s surplus is now poised to expand if the yuan remains constant. It is potentially win-win-win, so to speak. Of course, it all depends on the assumption that raising the policy rate and balance sheet reduction (quantitative tightening) can be calibrated to achieve the same level of domestic tightening with a different exchange rate impact. A two central bank, two instrument world has to differ in some fundamental ways from a two central bank, one instrument world in order to create new possibilities for de facto coordination. And it depends on the assumption that the eurozone’s current momentum will allow the ECB first to scale back its easing and then start a tightening cycle. It makes sense to me, though. And I think I see hints of it all in Governor Brainard’s speech.   * QE2 also didn’t weaken the dollar much, which led some to underestimate the foreign currency impact of ECB easing. The absence of a bigger impact on the dollar reflected two things I think: (a) the dollar was fairly weak at the time; and (b) foreign central banks—setting the ECB aside—intervened heavily to keep their currencies from appreciating. All this matters—net exports never contributed much to the U.S. post-crisis recovery (a rise in exports did help the US in 2007 and the first part of 2008, and a fall in imports helped cushion the demand blow of the crisis in 2008 and 2009, but net exports subsequently didn’t do much—until the dollar’s 2014 appreciation). ** I liked a lot of the recommendations in the McKinsey study, but it really seemed to suffer from an omitted variable—namely the value of the dollar. I guess that is too obvious to generate consulting fees. But it clearly matters. Technology (see Richard Baldwin) isn’t confined to a single country’s workers any more. And the postulated positive impact on cheap gas on U.S. manufacturing has clearly been trumped by other variables (one example suffices: Aluminum was one of the postulated winners from cheap gas as it is hugely energy intensive), and, well, the gap between U.S. and global gas prices has shrunk significantly since 2014 as global prices have come down. The reality is that the U.S. manufacturing deficit soared back in 2014 and 2015, and shows no signs of coming down (the rise in the deficit actually preceded the rise in the dollar, as there was a surge in imports in 2014—but the dollar clearly had the expected impact on exports).

The proxies for Chinese intervention in May do not show any significant reserve drain

Since the end of 2012, the yen has depreciated significantly and the dollar has appreciated significantly. Enough time has passed to look at how U.S. and Japanese exports have responded to these exchange rate moves. Both countries' exports are also shaped by global developments—the oil/commodity price shock of 2014 slowed emerging markets' import demand, for example. But there should still be information content in the relative performance of U.S. and Japanese exports. And guess what, exchange rates matter. Certainly the different trajectories of the dollar and yen would seem to provide the most straight-forward explanation for the relative performance of U.S. and Japanese exports (using the cumulative contribution of exports to real GDP growth as the measure of performance).* The same point holds for net exports—the overall trajectory of Japanese and U.S. imports has been remarkably similar, though I suspect for somewhat different reasons (Japanese import growth has been weak after 2014 because of weak consumption growth, U.S. import growth has been weak because of weak investment growth—and an inventory correction, though there are now signs U.S. import growth is picking up). Net exports clearly have helped Japan and hurt the U.S. over the past several years. If you step back a bit and plot the cumulative contribution of net exports to Japanese and U.S. growth since say the end of 2004 (there is no perfect starting point) there is a decent (inverse) correlation between cumulative growth in net exports and changes in the real effective exchange rate for both countries.   Note that for the U.S. the depreciation in 2003 likely had an impact on the size of change in real net exports after 2004 as well, given the lags. Net exports are once again up substantially since the end of 2004 for Japan (even with the need to substitute imported gas for nuclear power). And net exports are no longer up much for the U.S. since the end of 2004 (even with the dramatic reduction in U.S. net oil imports that resulted from the huge growth in U.S. production of light tight oil) The exchange rate swings of the last five years have changed the picture dramatically relative to say 2012.   The positive impact of the dollar's 06 to 13 weakness is fading from the data.   And the contribution from real net exports to Japanese growth in the past four or so years looks increasingly similar to the contribution of real net exports to Japanese growth back in 05,06 and 07—another period of yen weakness. The strong contribution to growth from net exports recently is one reason why Japan’s current account surplus is now running at close to 4 percent of its GDP ($184 billion in 2016).  The rise in Japan’s external surplus offset some of the 2016 fall in China’s current account surplus, keeping Asia's overall surplus up. And I think there is growing evidence that the depreciation of the yuan in 2015 and 2016 is also starting to have an impact on global trade. In 2015 and 2016 I suspect China's export performance was slowed by the lagged impact of the yuan's appreciation in 2014 (the yuan followed the dollar up against a basket). But now the impact of the 2014 appreciation is fading, and the 2016 yuan depreciation is starting to show. China's May’s export volume growth looks to be around 8 percent—in line with the average for the first four months of the year (China only reports y/y changes in volumes, and the numbers are distorted by the new year, so there is no perfect method of getting the number). That is likely a bit faster than the roughly 4 percent y/y growth in global import demand in the IMF's forecast.     My guess is that China’s export volume growth this year will exceed global export volume growth. As one would expect given the yuan’s depreciation since mid-2015. Exchange moves still tend to have predictable consequences. Chinese import volume growth continues to be fairly strong (April was relatively, but May looks solid). But as China’s credit tightening starts to bite, I would not be surprised if China’s surplus also starts to rise— * The q1 2013 jump in Japan's exports was matched by a parallel jump in Japan's imports.  The symmetrical revisions seem to reflect from a revision in the national income product accounts.  I did not revise the numbers to strip out the effect.  It has no impact on the trajectory of net exports.  

The U.S. trade deficit jumped in April—after staying roughly flat in the first quarter. Real goods exports in April were just below their q1 average. Real goods imports were a bit higher than their q1 average. Given the volatility in the monthly data it is too soon to say much about how trade will impact q2 growth—but if both imports and exports stay at their April level, the drag will be noticeable. I have a strong prior here—I expect the lagged impact of dollar appreciation in 2014 and 2015 to have an impact on the trade balance this year. The lags on exchange rate moves are long, and, well, I expect that weakness in investment and an inventory correction shifted some of the adjustment in imports that one normally would expect after a large currency move from 2016 to 2017.    A quick reminder: exports have responded more or less as expected to the dollar’s 2014-15 appreciation, imports have responded by less than would be normally be expected. Imports though are growing at a decent clip now. Imports of capital goods are up (the graph shows the sum of capital goods and auto imports, but the dynamic is stronger in capital goods). And consumer goods imports are growing again. Given that the U.S. imports far more goods than it exports (especially if you look only at manufactures), similar rates of growth imply an expanding deficit. (The monthly data on services, apart from the tourism numbers, is based on a lot of estimates and tends to be revised; it thus lacks the information content of the goods data). Looking at the bilateral data now almost feels like a political statement.   I confess that I find the bilateral numbers useful—though I certainly do not think the bilateral balance should be the target of policy (the “port” effect on the bilateral is real—look at the U.S. surplus with Singapore and Hong Kong and the Netherlands. I generally combine U.S. exports to China and Hong Kong for just this reason).   The bilateral data can help confirm broader themes. For example, the rise in the U.S. bilateral deficit with China—even with nominal export growing at a decent year-over-year clip—is an illustration of the broader pickup in U.S. goods imports. Nominal U.S. imports from China are up 7 percent by the way (year to date 2017/ year to date 2016), and they appear to be once again rising faster than the overall growth in capital and consumer goods imports. Evidence, perhaps, of a lagged response to the 2015-16 depreciation of the yuan? The U.S. numbers on imports from China are consistent with the overall strength in China’s exports in the Chinese data: Chinese monthly export volume growth this year has averaged 8 percent, and real goods exports were up 7 percent (y/y) in April.   This is a bit faster than April growth in Chinese import volumes  (import volumes though were up enormously in q1).  I will be interested to see if May confirms this as a trend. U.S. exports across Asia are also growing strongly, pulling the headline U.S. bilateral deficit with countries like Korea and Japan down.   That tells a couple of stories. Nothing much looks to be happening on U.S. exports of manufactures. But commodity exports are way up, both in nominal and real terms. Exports of agricultural products to Korea are up something like 50 percent (more for oilseeds), exports of ores are up something like 100 percent and exports of petroleum and natural gas are up even more. The pattern with Japan is similar. The fall in the bilateral balance with Japan and Korea is thus a reminder that that the U.S. is a major exporter of commodities, especially to Asia—and that exports of petroleum and natural gas now can have a significant impact on bilateral balances (even as the U.S. continues to be a net importer of oil and gas and thus the overall trade balance is hurt by a rise in the price of oil). U.S. exports to China and Hong Kong are also growing at a decent clip, for much the same reasons — and gold exports to Hong Kong also seem to be up.   Two cautions though.  Aircraft exports to China in q1 were weak.   That didn't have much of an effect on the year over year comparison because aircraft exports to U.S. China in q1 of last year were also weak.  I don't know what Boeing's delivery schedule looks like for the rest of the year, but if aircraft exports do not quickly return to their levels of late last year,  aircraft will start to pull the year over year numbers down.   And, well, the soybean harvest in Brazil has been good.    Prices are running a bit below their levels during the U.S. harvest last year as well ... 

The return of the "fix" doesn't answer the more fundamental question of how China intends to manage its currency.

Chinese reserves appear to be stable over last three months.

I confess that I probably am the only person in the world who—setting aside the internal politics of the Trump White House—would be excited to write the Treasury’s foreign currency report this quarter. Not because of China. I would say China met the existing 2015 manipulation criteria in the past and I would put the criteria under review (I personally think the bilateral surplus analysis should be complemented with value-added measures, which would reallocate some of China’s surplus to Japan, Korea, Taiwan, and the like). I might even find a way to warn that a country that guides its currency down can be guilty of manipulation under the 1988 law even if it is selling some of its foreign currency reserves (a controlled depreciation is hard, and usually requires reserve sales to manage the pace of depreciation). But not name China now. The U.S. would be completely isolated in naming China now, the impact of China’s 2016 stimulus seems to have been bigger than the impact of the renminbi’s depreciation and there is plenty of scope to get tough on China on other trade issues. As the Financial Times notes" "It is in no one’s interest, including the US, if Beijing suddenly stops intervening to defend the renminbi and a destabilising rush of capital flight and sharp devaluation follows." Rather, I would be excited to find ways of keeping the heat on Korea and Taiwan up, even if neither likely meets all three of the criteria in the 2015 Trade Enforcement Act. And, well, geopolitics probably is a constraint on getting too tough on Korea right now. It is often argued that countries won’t change their currency policies with a gun pointed to their heads, so explicit threats won’t work. Fair enough: threats do not always work (see the Freedom Caucus, health care). On the other hand, sometimes countries get a bit locked into a certain set of export promoting policies, and won’t change unless their feet are held to the proverbial fire. Korea for example still seems pretty comfortable intervening to keep the won in a band. It seems to have intervened again to limit the won's appreciation in late March (at around won 1115, the market has subsequently turned). And Korea's band is set in a way that keeps the won much weaker than it was before the global crisis, allowing foreign demand (via the trade surplus) to help offset the domestic impact of Korea’s weak social safety net, forced pension savings, and tight fiscal policy. And Taiwan has been comfortable with a weak New Taiwan dollar maintained in part through intervention and in part through encouraging Taiwanese financial institutions (life insurers) to invest ever larger sums abroad. The last Treasury foreign exchange report noted that Taiwan met the current account surplus and reserve accumulation criteria of the 2015 trade law. It escaped being dinged because of its small bilateral surplus with the United States. That report may have gotten Taiwan’s attention (I certainly tried to help the process along too). Taiwan’s intervention fell off a bit in the fourth quarter. And Taiwan is reported to have largely kept out of the market in the first quarter of 2017. That is one of the reasons why the New Taiwan dollar appreciated by about 5 percent against the U.S. dollar (and against the yuan—which probably matters more for Taiwan). As a result, Taiwan’s reported reserve growth (net of interest income) over the last four quarters of data (calendar 2016) dipped to right 2 percent of GDP (The Treasury threshold). That alone shouldn’t let Taiwan off the hook though. We don’t know how much Taiwan really intervened, because Taiwan doesn’t release data on its forward book (Taiwan has not voluntary adopted the SDDS disclosure standard, which it could do even if it isn't a member of the IMF). Taiwan claims it doesn’t intervene in the forward market, but, well, the old notion of “trust but verify” would seem to be relevant here. If Taiwan doesn’t have a forward book, it shouldn’t have a problem releasing the relevant data—including the historical data. Now the Treasury calculates reserve growth without explicit reference to the balance of payments data. It adjusts headline reserves for valuation, and it nets out estimated interest income. The Treasury's interest income adjustment—which is debatable, I personally think interest income should be sold for domestic currency, with the proceeds paying the coupon on domestic sterilization instruments and with any excess going into a reserve fund or sent back to the government—should help Taiwan. It should pull Taiwan's intervention below 2% of GDP in the Treasury's eye (the details of how you do the calculation matter it turns out). My gut is thus that Taiwan no longer meets two of the three existing Treasury criteria. So if Treasury sticks to those criteria, Taiwan likely has gotten itself off the watch list. Yet the battle isn’t over. Less intervention has meant that the New Taiwan dollar has appreciated a bit. But its currency is now getting back to its 2013 or 2014 levels (against the dollar). Taiwan may want to resume its intervention. Yet with a current account surplus that is still over 13 percent of GDP, it really should tolerate a bit more appreciation. There is one other thing, which is a bit more technical. Taiwan’s life insurers have a ton of foreign assets. And they have added to their foreign asset portfolio at a very impressive clip over the last several years when the New Taiwan dollar was weak. So long as the government intervenes to keep the New Taiwan dollar relative weak, they won’t take large losses on their investments. And as the new Taiwan dollar rises, they take losses. Fair. The risk of such losses helps deter large currency mismatches. But at some point they might need to hedge against the risk of further appreciation. That in turn could accelerate the move… Or put pressure on Taiwan’s central bank to intervene forward. Forward disclosure thus is absolutely critical.

Does China manage its currency against the dollar, against a basket, or to whatever is most convenient at any given point time? Cynics have argued that China seems to peg to the dollar when the dollar is going down and the basket when the dollar is going up. The yuan's moves in March at least raise the question again, even if the signal is relatively weak. The yuan has hewed fairly closely to the dollar over the last few weeks. And in March that meant some modest depreciation against the basket (though the depreciation against the basket was partially reversed in the first week of April when the dollar rose). In other words, had China managed more against a basket, the yuan should have appreciated a bit more against the dollar than it did. Managing the yuan against the dollar is in some ways less risky than managing against a basket, as Chinese residents still seem to focus on the yuan's value against the dollar. Stability against the dollar so far this year—and tighter controls— has contributed to the relative stability in China's headline reserves. It is likely that China is no longer selling all that much foreign exchange in the market, though we still need the settlement data and the PBOC balance sheet data to have a clear picture for March. But I still worry a bit. The risk all along has been that China’s new policy of managing its currency against the basket was masking a policy of managing its currency to depreciate against the basket. From mid-2015 to mid-2016 China used periods of dollar weakness to depreciate against a basket—and thus created the perception of a one-way bet. China needs to make sure such expectations do not reappear, whether by really managing against the dollar—even if that means following the dollar up—or really managing against a basket. One last point: it would be a shame if discussions around currency are defined entirely by the question of “manipulation or not.” It would be a stretch to argue that China is manipulating (there are lots of potential ways to define manipulation, but recently it has been defined as buying foreign exchange in the market to hold your currency down and support a large current account surplus -- and China clearly has selling foreign exchange in the market to support its currency over the past year, and its stimulus has brought its current account surplus down). But the way China manages its currency matters—to the U.S. and to the world. The value of the yuan, more than any other single factor, determines whether it makes sense to locate production in China for U.S. sales, or locate production in the U.S. for sales to China. Of course sectoral barriers matter. But in theory, restrictive Chinese policies in one sector should be offset in part by moves in the currency—fewer Chinese imports should mean a stronger currency, and fewer exports. The sectoral barriers thus matter for particular firms, but the exchange rate matters for the broader economy.* That is why I think China's currency management needs to remain on the bilateral and multilateral agenda and why I disagree with those who argue that other issues (notably the ability of U.S. firms to invest more freely in China) matters more to the U.S. economy than the level of the exchange rate. * As an example, total U.S. beef exports are around $6 billion, with $1.5 billion in exports to Japan and almost $700 million to Hong Kong (call me cynical, but I would not be surprised if some U.S. beef already enters the Chinese market). Even if China started to buy two times as much beef as Japan ($3 billion), it wouldn't really change the overall trade balance by much. U.S. pork exports to China have gotten a lot of attention, but total pork exports to China and Hong Kong still total only around $1 billion a year (total pork exports to the world are $6 billion). Changing the overall trade balance really requires changing the incentives facing a broad set of industries - something that is most easily achieved through a change in the exchange rate.

Martin Wolf’s important column does a wonderful job of illustrating the basic risk China poses to the world: at some point China’s savers could lose confidence in China’s increasingly wild financial system. The resulting outflow of private funds would push China's exchange rate down, and rise to a big current account surplus—even if the vector moving China’s savings onto global markets wasn’t China’s state. History rhymes rather than repeating. And I agree with Martin Wolf’s argument that so long as China saves far too much to invest productively at home, it basically is always struggling with a trade-off between accepting high levels of credit and the resulting inefficiencies at home, or exporting its spare savings to the world. I never have thought that China naturally would rebalance away from both exports and investment. After 2008, it rebalanced away from exports—but toward investment. There always was a risk that could go in reverse too. In one small way, though, I am more optimistic than Martin Wolf. I suspect that China’s regime was under less outflow pressure in 2016 than implied by the (large) fall in reserves, and thus there is more scope for a combination of “credit and controls” (Wolf: "The Chinese authorities are in a trap: either halt credit growth, let investment shrink and generate a recession at home, a huge trade surplus (or both); or keep credit and investment growing, but tighten controls on capital outflows") to buy China a bit of time. Time it needs to use on reforms to bring down China’s high savings rate. All close observers of China know that China has been selling large quantities of reserves over the last 6 or so quarters. The balance of payments data shows a roughly $450 billion loss of reserves in 2016, with significant pressure in q1, q3, and q4. The annualized pace of reserve loss for those three quarters was over $600 billion (q2 was quite calm by contrast). But close examination of the balance of payments indicates that Chinese state actors and other heavily regulated institutions were building up assets abroad even as the PBOC was selling its reserves. In other words, a lot of foreign assets moved from one part of China’s state to another, without ever leaving the state sector. For a some time I have tracked the balance of payments categories dominated by China’s state—and, not coincidentally, categories that experienced rapid growth back in the days when China was trying to hide the true scale of its intervention. One category maps to the foreign assets the state banks hold as part of their regulatory reserve requirement on their deposit base. Another captures the build up of portfolio assets (foreign stocks and bonds) abroad, as most Chinese purchases of foreign debt and equity historically has stemmed from state institutions (the state banks, the CIC, the national pension fund). Even if that isn't totally true now, portfolio outflow continues to take place through pipes the government controls and regulates. These “shadow reserves” rose by over $170 billion in 2016, according to the balance of payments data. The state banks rebuild their foreign currency reserves after depleting them in 2015, and there were large Chinese purchases of both foreign equities and foreign debt. And the overseas loans of Chinese state banks—an outflow that I suspect China could control if it wanted to—rose by $110 billion. As a result much of the foreign exchange that the central bank sold ended up in the hands of other state actors. My broadest measure of true official outflows* shows only $150 billion in net official sales of foreign assets in 2016. Not a small sum to be sure. But not an unmanageable sum. That kind of outflow can easily be financed out of China’s large foreign exchange reserves for a time, or China could more or less bring the financial account into balance by limiting the buildup of foreign assets by the state banks and simultaneously cracking down on outward FDI (over $200 billion in outflows 2016, and largely from state and state-connected companies). In other words, much of the reserve draw was offset by the buildup of other state assets—especially counting the assets state banks and state firms acquired abroad.** That I suspect is why flows suddenly started to balance once China tightened its controls (and likely made it harder for one part of the state to bet against another part of the state). Of course, the renminbi’s relative stability against the dollar also helped—you do earn more on a bank deposit in renminbi than on a bank deposit in dollars. There are of course still private outflows. But the outflows aren’t that much bigger than what China could finance out of its export surplus. If you take the growth in the state banks' overseas assets ("other, other assets" and "other, loans, assets" for the BoP geeks) out of the data, it seems that the pace of outflows actually slowed a bit in 2016. Of course, I do not like simple stories. I think the outflow numbers on the financial account are a bit less scary after you adjust for the financial activity of China's state, but I also think the current account may disguise some real private outflows. Bottom line: the 2016 reserve drain was offset in part by the buildup of assets at the state banks and in other large regulated financial institutions, so it is a bit less scary than it seems—for now. Especially in a context where China’s growth is accelerating, China is on a tightening cycle and, for now, the dollar isn't appreciating in the way many expected. * This measure includes the foreign loans of China's banks (assuming, correctly, that all the major lenders are state-owned), the traces the PBOC's other foreign assets leave in the balance of payments data (other, other, asset -- which reflects the foreign assets the banks hold as part of their regulatory reserve requirement on domestic deposits) and portfolio equity and debt. Historically, the CIC has dominated portfolio equity outflows and the state banks accounted for most portfolio debt outflows. That is a bit less true now, so this arguably over-counts. If that is the case, I would welcome a revision to the Chinese balance-of-payments data that splits out China's holdings of portfolio assets abroad by sector -- consistent with the reporting provided by many other countries. One thing though is clear: portfolio outflows are governed by quotas and are executed through channels the state regulates. They cannot happen without state approval. ** This would explain in part why the data on fx settlement, which includes the state banks as well as the PBOC, shows fewer sales than implied by the change in the PBOC's foreign balance sheet.

It should go almost without saying that China’s ability to maintain its current exchange rate regime matters. The yuan has been more less stable against the CFETS basket since last July. If the current peg breaks, China will struggle to avoid a major overshoot of its exchange rate. Christopher Balding recently has argued that the fall in the dollar (on say the Fed’s dollar index) in 2017 is more or less the same as the yuan’s depreciation against the basket—which would make China’s exchange rate regime now more a pure peg against the dollar rather than a true basket peg. Hence the lack of movement against the dollar in past few weeks. Maybe. I though am inclined to think that the yuan’s depreciation against the basket this year just undid the upward drift against the basket that came when the dollar appreciated last year, and China is still aiming to keep the currency more or less stable against the basket, not stable against the dollar. Time will tell. Right now, the exact nature of China’s peg now matters less than China’s ability to maintain some kind of peg, and thus to avoid a sharp depreciation. If there is a depreciation, either the world will absorb a new wave of Chinese exports—a 10 percent real effective exchange rate depreciation should raise China’s real trade balance by about 1.5 percent of China’s GDP, or by roughly $180 billion (using this IMF study as a baseline for the estimate, it is summarized here)—or a wave of protectionist action will limit China’s export response, and in the process threaten the global trading rules.* Neither is a good outcome. The data for the next few months will be critical. China does seem to have tightened its outflow controls—despite the official denials. FDI outflows certainly have slowed. Hopefully the screws will be placed on a few other categories of outflows—there are plenty of categories in the balance of payments that show a buildup of foreign assets that, in my view, should be controllable. The rise in Chinese bank loans to the world, for example. I also still think the yuan’s movement against the dollar is an important driver of outflows, so a sustained period of stability in the yuan’s exchange rate versus dollar—whether because the broad dollar is falling and that means the yuan needs to rise to maintain a basket peg, or simply because China starts to prioritize stability versus the dollar—should lead to a reduction in pressure.** Finally China does seem to be tightening its domestic policy, at least a bit. Higher money market rates should also help support the yuan. The proxies for intervention for January do suggest some reduction in pressure in January—though pressure by no means entirely went away. The FX settlement data, adjusted for reported forwards, shows net sales by the banking system of just under $20 billion. That is down from $36 billion in November, and $54 billion in December. The PBOC’s balance sheet data shows a $30 billion fall in foreign reserves, and a $60 billion fall in foreign assets. That can be compared to an average monthly fall—on both measures—of around $45 billion in the fourth quarter of 2016. I typically prefer foreign assets to foreign reserves, because foreign assets captures the foreign exchange the banks hold at the PBOC as part of their regulatory reserve requirement—and in the past, changes in the banks required reserves have been a tool that the central bank has used for shadow intervention. However, the January fall looks to be something else. In the past, changes in the PBOC’s foreign assets—at least those that mapped to backdoor intervention—generally have been correlated with changes in the settlement data (this makes sense, the PBoC’s other foreign assets are in part the banks required reserves, and the settlement data aggregates the central bank and the state banks). One story is that the PBOC has changed how it accounts for its contribution to the IMF. But until that story is confirmed, the fall in other foreign assets has to be part of the calculus. While the gap between the settlement number and the change in the PBOC’s balance sheet is particularly large in January, a smaller gap has been present for a while. The PBOC’s balance sheet data thus implies slightly larger outflows than the settlement data. Bottom line: The balance of evidence suggests a moderation in pressure on China’s exchange rate regime in January—but a moderation in pressure isn’t the same as an end to the pressure. Unlike some, I do not think China’s fundamentals require a depreciation. The current account remains in surplus, China’s export market share has held up well—and China is (once again) growing faster than most of the world. But sustaining the current basket peg will be hard if outflows do not moderate. * I recognize that a rise in protectionism is a possible outcome even if China doesn’t move ** If stability or appreciation against the dollar doesn’t materially reduce reserve loss over a several month period, I would need to reevaluate my priors

$2.7 trillion is well over 3 times China’s short-term external debt (around $800 billion per the IMF). It is roughly two times China’s external debt ($1.4 trillion, counting over $200 billion in intra-company loans). It is enough to cover well over 12 months of goods and services imports (total imports in 2016 were around $2 trillion).* There are two good reasons why a country might need more reserves than it has maturing external debt. The first is that it has an ongoing current account deficit. A country arguably should hold reserves to survive one year without any external financing – the sum of the current account and short-term external debt. The other is that a country has lots of domestic foreign currency deposits. Neither applies to China. China’s runs a $200 to $300 billion current account surplus, so its one year external financing need is now around $500 billion. China has a relatively modest $250-$300 billion in foreign currency sight deposits, and just under $600 billion in domestic foreign currency deposits (to put that in context, it is about 5 percent of GDP). It would take just over a trillion in reserves to cover China’s external (short-term debt) and internal (domestic fx sight deposits) fx liquidity need. The $2.7 trillion number (or $2.6 trillion) stems from the initial application of the IMF’s new (and in my view flawed) reserve metric to China. The IMF’s metric revived M2 to reserves as an important indicator of reserve adequacy, and China is off the charts on this indicator (China has very little external debt, but a very large domestic deposit base – so a composite indicator that includes the domestic deposit base gets a very different result than metrics that focus on external debt). In the composite indicator, emerging economies with a fixed exchange rate and an open capital account need to hold 10% of M2 in reserves. That alone is about over 20% of China’s GDP – as China’s M2 to GDP ratio is a bit over 200%. For China, the weighted contributions from short-term debt, “exports” (the IMF uses exports rather than imports) and long-term external liabilities are trivial. For China, the entire reserve need more or less comes from one of the four variables in the IMF’s composite indicator (more here). But that calculation is now outdated. The IMF has refined its metric to give more weight to the presence of capital controls, and China has tightened its controls. Assuming that there are capital controls, the IMF metric indicates that China would be fine with $1.8 trillion in reserves (though that sum rises over the course of 2017, thanks to the ongoing growth in M2 as a share of GDP).** I am not a fan of the even the updated new metric. I am not a big fan of composite metrics in general. And if you are going to use a composite metric, I think the composite metric should put more weight on foreign currency deposits than domestic currency deposits, while the IMF’s metric typically weights all domestic deposits at 5%. The IMF’s metric thus ignores one of the key insights of balance sheet analysis. No matter. The world would be in a better place if there was a broad recognition that China can burn through another $1 trillion in reserves and, with $2 trillion still in reserves, be above every nearly all metrics of reserve adequacy. This isn’t to downplay the scale of China’s reserve loss. The BoP data shows a reserve outflow of a bit more than $440 billion in 2016. That is significant. But I suspect that much of the outflow that led to the fall actually was the state actors. The build up of foreign assets in the banks, loans from the state banks to the world and easily controllable portfolio outflows from large institutions likely accounted for about $250 billion of the total fall in reserves. This leaves the true fall in the total foreign assets of China’s state sector at more like $200 billion. Still big, but not quite as big. Set that debate aside though. The reason for concern about China is the rapid pace of the reserve decline, not the risk that China is about to run out of reserves. China might conclude it doesn’t want to continue to finance outflows with reserves, in which case its currency would depreciate until the trade surplus was large enough to finance the outflow. One final point. The IMF’s initial metric implied China needed far more reserves, relative to its GDP, than other emerging markets economies – more than Brazil, more than Turkey, more than Russia, more than Ukraine (see this post, or play with the IMF’s data tool***). That never made sense to me, even though China does have a more managed exchange rate than most. Domestic capital flight can force a country off a peg, no doubt – but the negative macroeconomic impact of a depreciation is proportionate to the amount of foreign currency debt in the economy, not the size of the domestic deposit base. *  The IMF metric uses exports rather than the traditional imports, but China is just fine using exports too. China’s export to GDP ratio has come down after the global financial crisis. ** In the absence of capital controls, the IMF’s latest reserve metric spreadsheet suggests China now needs more than $2.7 trillion using the 10% of M2 weighting, incidentally. The estimated 2017 reserve need is -- gulp -- $3.3 trillion. One way of interpreting that is that China lacks the reserves to open its financial account if it wants to continue to manage its exchange rate. Another way of interpreting it is that the metric doesn’t really work for an M2 to GDP outlier like China. *** The IMF’s reserve data interface is now quite useful. And all the underlying data is available in a convenient spreadsheet. That makes it easy to check out the contribution of various components. I would be thrilled if the IMF added the foreign currency/ domestic currency split of M2 so that those of us who are interested in the foreign currency deposit base would have a new resource for cross country comparison.

Late last year Tim Duy asked for an assessment of the decision to allow China to join the WTO, now that 15 years have passed. Greg Ip met the call well before I did, in a remarkable essay. But I will give my own two cents. Be warned, this isn’t a short post. Frankly it is an article disguised as a post. I added the subheadings to make it a bit easier on the eye. Autor, Dorn, and Hanson Deserve All the Attention They Have Received It now seems clear that the magnitude of the post-WTO China shock to manufacturing was significantly larger than was expected at the time of China’s entry into the WTO. China already had “most-favored-nation” (MFN)/“normal trade” access to the U.S. market, so it wasn’t clear that all that much would change with China’s WTO accession. But China’s pre-WTO access to the U.S. came with an annual Congressional review, and the resulting uncertainty seems to have deterred some firms from moving production to China. The domestic labor market adjustment to the “China” shock was not smooth. Autor, Dorn, and Hanson’s research shows the China shock left a significant number of Americans temporarily without jobs and left some workers and communities permanently worse off. The U.S. labor market isn’t as homogenous or as flexible as many thought; displaced workers in the most exposed regions often dropped out of the work force rather than finding new, let alone better, jobs. Similar effects to those that Autor, Dorn, and Hanson found in the U.S. also seem to be present in manufacturing intensive parts of a number of European countries (France, for example). Bob Davis and the Wall Street Journal also deserve credit for their reporting on this topic: Davis and his colleagues really helped flesh out the narrative that goes with the Autor, Dorn, and Hanson data. Not All China—The Underreported Impact of Dollar Strength (2000-2002) All that said, the shock from the rise in imports that came with China’s WTO entry was not the only source of the enormous decline in manufacturing jobs between 2000 and 2005. The broad strength of the dollar from 2000 to 2002 mattered. The late 1990s were actually pretty good years for U.S. manufacturing even with a relatively strong dollar. In the late 1990s the strong dollar came hand-in-hand with a surge in domestic U.S. demand for American-made as well as global manufactures. The data superhighways of the 1990s were often built with U.S. made equipment. The booming stock market—and low oil prices in the 1990s—created demand for “big” U.S. made SUVs. However, the strength of the dollar weighed on the U.S. economy after U.S. demand for capital goods collapsed. In the aftermath of the dot-com era and the collapse in domestic demand for capital goods, the U.S. needed to turn to exports to have a healthy economy—and from 2001 to 2003 exports fell along with domestic demand, leading a lot of manufacturing capacity to leave the U.S. With the benefit of hindsight, I sort of think that Treasury Secretary Paul O’Neill should have rented out Yankee Stadium to announce a shift in dollar policy back then. The dollar bubble burst in 2003. But the dollar only fell against the euro and some other major currencies. It didn’t fall against China, or fall by much against many Asian currencies. 2003 is really when China and others started intervening on an unprecedented scale to keep their currencies undervalued. China was hardly adding to its reserves at all when it joined the WTO. At the time, annual reserve growth, using my best estimates which attempt to count all hidden or shadow intervention, was 2-3 percent of China’s GDP. By 2006 it was ten percent of China’s GDP (counting hidden intervention through the banks); by 2007 it was 15 percent of China’s GDP (counting a new form of hidden intervention through the state banks). Based on the work of Joe Gagnon of Peterson Institute and his co-authors, I think that China’s intervention from 2003 to 2008 added between 3 and 6 percentage points to its current account surplus (I could argue for a higher number, actually—see the footnotes here). The market wasn’t allowed to work for a long time—China’s exchange rate didn’t really start to appreciate in a way that would push firms to reconsider their production structure until late 2007. By then much of the damage had been done. There seems to be a bit of path determinacy in the location of production decisions (to be fancy, hysteresis). Once industries and supply chains move to low-cost emerging economies, they have tended to stay put. Moving final assembly of electronic goods to Asia created pressures for the full supply chain to move to Asia, as Bradsher and Duhigg documented back in 2012. WTO Accession Didn’t Make China an Easy Market for Other Countries’ Exports Even if the currency issue is taken off the table, I suspect that the trade gains—or really the export gains— from integrating China into the WTO’s “rules” were overestimated. It is now clear that WTO accession was not enough to make China into an easy market for foreign firms to supply from outside China. Here is a point that I think should get a bit more emphasis. China’s imports of manufactures, net of its imports of imported components, peaked as a share of Chinese GDP in 2003—and have fallen steadily since then. There is no “WTO” effect on China’s imports of manufactures, properly measured (i.e. leaving out imports for re-export). Chinese imports of manufactures for China’s own use are now under 5 percent of China’s GDP—a low number compared to China’s peers. As a result, right now, China supplies roughly three times as many manufactures to the world as it buys for its own use (net of processing imports, manufactured exports around 12.5 percent of China’s GDP; net of processing imports, manufactured imports are around 4.5 percent of China’s GDP, for a manufacturing surplus of around 8 percent of China’s GDP). Back in 2000 and 2001, China was expected to do well in the production of apparel and low-end consumer goods. But it was also expected to be a big market for a wide range of sophisticated U.S. and European capital goods. Broadly speaking that hasn’t been the case, setting aircraft aside. Some firms have succeeded in China, but generally by producing in China for the Chinese market, not by selling to China. Successful challenges to some specific Chinese practices in the WTO have yet to alter this pattern. Mark Wu’s excellent article offers a plausible explanation for why. The WTO rules aren’t all that constraining in a country like China—thanks to state control of commanding heights enterprises and banks, and institutions, such as the National Development and Reform Commission (NRDC), that assure party control of major state firms and large investment projects. Let me be concrete, and offer a few examples. McKinsey’s 2016 China outlook notes that Chinese firms are now among the world leaders in wind turbines and high speed rail: “[China has the] potential to carve out a world-leading position in pharmaceuticals, semiconductors, and communications equipment in the way that it has done in high-speed rail and wind turbines.” Yet China’s success in rail and wind wasn’t exactly a product of the magic of the market. The Chinese used the purchasing power of the railway ministry to encourage foreign firms to form joint ventures with Chinese firms to develop China’s high speed rail infrastructure, and over time the foreign technology was “digested” by Chinese firms. And in wind power, equipment from Chinese companies got preference in the bidding for large wind farms to supply the state controlled power grid (even if sometimes the grid hasn’t always figured out how to make use of resulting energy supply, at least not yet).* The state’s hand was clear, but not in ways that were obviously forbidden by the WTO. Or at least not in ways that have been successfully challenged in the WTO. Firms’ investment decisions aren’t technically government procurement if the investment is for the provision of a commercial service, and the state’s guidance isn’t always written down. Yet even today the preferences provided for local firms in strategic sectors, like medical equipment, aren’t exactly a secret that China tries all that hard to hide. McKinsey again: "Mindray, United Imaging Healthcare, and other smaller new Chinese players will continue to make inroads in market categories (for instance, CT scanners and MRI machines) that foreign suppliers now dominate. Government programs to subsidize purchases of Chinese-made equipment by the country’s hospitals are providing a boost…" There are a few important sectors where Chinese demand isn’t met locally: notably aircraft (though China has plans for import substitution there) and high-end autos. But not nearly as many as would be needed for trade with China to be reasonably balanced, given China’s dominance in electronics manufacturing—and its increasing powers across a range of “engineering” sectors. The U.S. for example, runs a significant trade deficit in capital goods with China (even after taking out computers). That wasn’t the expectation back in 2001. As an aside—I fully recognize that China naturally will run a surplus in manufactures and import primary products/commodities: looking at manufacturing in isolation is a very partial analysis. Chinese demand for commodities did deliver large positive spillovers to commodity producers globally, even as higher commodity prices squeezed the real incomes of a lot of commodity consumers globally. Agreed Safeguards Against Import Surges Were Under-Used In the face of a China that didn’t deliver the expected market for manufactured exports from the advanced economies—and in the face of foreign exchange market intervention that reached 10 to 15 percent of China’s GDP in the period that immediately preceded the crisis—the U.S. and Europe remained relatively open to Chinese imports. Mark Wu argues, correctly, that the WTO accession agreement provided a set of provisions that were designed to help manage the risks associated with China’s integration: the “non-market economy” provision, which made it easier for U.S. firms to bring dumping cases against China; and the “special safeguards” provision, which lowered the standard required for imposing temporary tariffs against a surge in imports from China for the twelve years after China’s WTO accession. The non-market economy provision was certainly used, notably by the steel industry. The special safeguards provision (section 421) wasn’t used much at all. In no small part, this is because U.S. and European firms benefited from making use of Chinese production to meet global demand. The interests of U.S. firms and U.S. labor were not always aligned. But 421 safeguards also were not used because the remedy if a function of discretionary decisions made by the executive branch, and the Bush 43 administration made it clear it wasn’t going to hand out safeguards easily. Robert Lighthizer, back in 2010: “Between 2002 and 2005, the U.S. International Trade Commission ("ITC") heard four cases in which it determined that the requirements for a China-specific safeguard had been met. In every case, however, the Bush Administration exercised its discretion to deny relief – effectively rendering Section 421 a dead letter. Indeed, after 2005 U.S. companies stopped even applying for safeguard measures from the Bush Administration. Thus, for much of the time that Section 421 was supposed to be available to U.S. companies, the U.S. government refused to provide any relief” With the benefit of hindsight, I think it was a mistake not to make greater use of the 421 safeguard provision in the years following China’s WTO entry.** There were surges of imports left and right from 2002 to 2007 (and additional surges in imports of machinery in particular from 2010 to 2014). These surges had a material impact on many manufacturing dependent communities, especially in the American Midwest and Southeast (and in some smaller towns on the west coast that were part of the U.S. tech manufacturing sector). The threat of injury should not have been hard to show. I also think there was a "421" based option—and an option that was within the agreed accession rules—that could have been used to respond to the initial China shock more effectively. The U.S. could have signaled that so long as China was intervening heavily to hold its currency down, it would be open to a ton of 421 safeguards cases—and hand out real sanctions in response.*** This would not have required Congressional action, nor would it have created a broader precedent that might be used against other countries that intervene to hold their currency down—unlike the various incarnations of the Schumer legislation. Some say that China would never have responded to public pressure on its currency, but I suspect that it would have found a way to shift its policy in the face of real sanctions that hindered China’s ability to export. And politically, the U.S. government would have put itself squarely on the side of those adversely affected by China’s policy of supporting its exports while hindering others’ exports into China.**** (Alternatively, the use of safeguards could have been linked to a request to change policies that were clearly impeding firms from producing outside China for sale inside China, though I personally prefer the currency ask as the main driver of adjustment: currency is market-based, and it doesn’t depend on successfully identifying and changing a ton of China’s domestic policies) Concluding Thoughts The initial China shock overlaps with the dollar shock. WTO accession made producing in China for the global market attractive, but did not made China into a great market for manufacturers looking to sell globally produced goods to China. Successful WTO challenges to individual Chinese practices haven’t changed the overall pattern—China’s imports of manufactures for its own use have slid steadily relative to China’s GDP after WTO accession. The more-limited-than-expected gains for manufacturers looking to sell to China though didn’t lead (until now, when the China shock is arguably starting to fade) to a serious reconsideration of the basic gains from China’s asymmetric integration, in part because U.S. and European firms captured many of the initial gains of China’s export success. And some “within the rules” remedies weren’t used as aggressively as they could have been to challenge China’s currency management and other discriminatory practices during the years immediately after China joined the WTO.** One final note. There is a huge difference between the 2002-2012 period and now. China’s currency was clearly under pressure to appreciate during most of that period, so letting the currency appreciate was the obvious option for bringing China’s trade into greater balance (the empirical evidence here is actually quite clear, Chinese exports and its trade balance respond as one would expect to changes in the real exchange rate). China is a more difficult problem, at least intellectually, now than then. There is a plausible argument that—if capital controls are lifted and if China’s system of social insurance remains miserly so savings remains high—the natural market outcome is for China to export more savings and even more goods than it does now to the world. Fighting China’s intervention is in some ways fighting the last war. The correct fight right now is against the domestic policies that keep China’s savings so high, against a surge in capital outflows that leads to a yuan depreciation that then becomes entrenched (if China’s currency goes down, I worry it won’t go back up), and against Chinese import-substituting industrial policies that aim to displace major exports to China. Aircraft and semiconductors come to mind, but there are no doubt others (medical equipment?).***** China’s import-substituting industrial policy aims are at odds with a world that needs more Chinese imports (and less Chinese savings) to be in better balance. Note: Edited to remove a few type-os subsequent to posting. * For more on China’s policy of import substitution on high speed rail, see the FT’s Jamil Anderlini, a few years back: "these companies have spent years ‘transferring’, or selling, technology to state-backed partners in exchange for market access—only to be rewarded with shrinking market share in China as a result of state policies that favour local industry. Now these companies find their high-speed technology has been “digested”—defined by the government as a multistep process of buying foreign technology, innovating on that existing platform then selling it under a domestic brand—by former Chinese partners. Furthermore, the foreigners find themselves competing head-to-head for tenders all over the world with Chinese companies selling digested high-speed technology at discount prices, often with cheap state bank financing thrown in." For more on import substitution on wind, see McKinsey’s Orr: "The wind turbine market in China is a clear example of the virtuous (for China) cycle that China’s industrial policy is sometimes able to deliver. Government-owned generators are the core customer for the turbines. They receive subsidies from the government for installing these turbines. The size of the market in China quickly grows to become the largest in the world. Government policy skews the market towards Chinese producers." ** I am well aware of the argument that the tires safeguard raised import prices and hurt consumers, while doing more to raise tire production in Thailand, Malaysia, Indonesia, and Taiwan than in the U.S.. I also suspect that if anyone looked closely, they would find that China’s counter-sanctions on U.S. chicken feet exports were less effective than the U.S. tariffs on tires. Someone should look closely at the data on chicken parts trade through Hong Kong in 2009 and 2010—trade spats are so glamorous. I also am aware that negotiating leverage comes in part from the threat of taking actions that have a real impact on the other side, even if that comes at a cost to your own consumers. *** I am dodging the question of whether this should be done in conjunction with a finding of manipulation. Remember manipulation is just a name. The designation matters less than the combination of sticks and carrots that could be brought to the table. A linkage could have been made between safeguards and currency without a formal designation, or it could have been done subsequent to a designation. The argument against designation is that it would make any appreciation into a loss of face. That argument has to be weighed against the fact that persuasion didn’t deliver much of a shift in China’s currency from 2003 to mid 2007 (the big move against the dollar was from mid 2007 to mid 2008; that one year period now accounts for about half of the cumulative appreciation from 2001 to 2016). I also am setting aside the option of using counter-vailing duties to combat currency undervaluation (or to counter the effects of intervention more specifically) in order to highlight the scope for using a “within the agreed rules” option. I personally favor well-designed counter-vailing duties for currency intervention, though only as a back-up if counter-intervention doesn’t work – but that is a topic for another time. **** 421 safeguards also could have been used more aggressively in the early part of the Obama administration, though the case isn’t as clear as it was in the 2003 to 2007 period, as there weren’t quite as many import “surges” after the crisis—and the fact that the provision was set to expire in 2013 reduced interest in the remedy. ***** China is within its WTO rights to levy a 25 percent tariff on imported autos, but I think the high tariff here -- in a sector where China actually imports significant sums from the rest of the world -- ought to get a bit more attention. If China wants to be global trade leader, it could unilaterally bring its tariffs down to world levels. The EU’s tariff on autos is relatively high, but at 10 percent, it is well below China’s tariff.

The pace of decline in China’s foreign reserves matters. Not because China is about to run out. But rather because China will at some point decide that it doesn’t want to continue to prioritize “stability” (against a basket) and will instead prioritize the preservation of its reserves, and let the yuan adjust down. Significant voices inside China are already making that argument. And I fear that if the yuan floats down, it will stay down. China will want to rebuild reserves, and—if exports respond to the weak yuan—(re)discover the joys of export-led growth. Relying on exports is easier than fighting the finance ministry’s opposition to a more expansive (on-budget) fiscal policy, or seriously expanding the provision of social insurance to bring down China’s savings. I thus disagree with those who argue that the “China” shock is over. It depends a bit on the exchange rate. China’s exports of apparel and shoes have probably peaked. But China’s exports of a range of machinery and capital goods continue to remain strong—and at a weaker exchange rate, China could supply more of the components that go into our electronic devices, and export far more auto parts, construction equipment parts, engines, generators, and even finished autos than it does now. “Mechanical” engineering writ large continues to be a significant part of the U.S. economy, and even more so the European economy. One of the main indicators—PBOC balance sheet reserves—that I follow for tracking China’s reserve sales is now out for December, and it points to around $45 billion in sales. I prefer to look at all the foreign assets the PBOC reports on its balance sheet rather than just its reported foreign exchange reserves. That variable was down $43 billion in December, and $133 billion for q4. Actual foreign exchange reserves fell by a bit more—$46 billion in December and $141 billion in q4. The difference between foreign exchange reserves and all of the PBOC’s foreign assets is primarily the foreign exchange the banks hold at the PBOC as a result of their reserve requirement. The loss of reserves in December was a bit smaller than in November. But only just. The average monthly fall in q4 was over $40 billion. That is a pace that is ultimately unsustainable. I think China would be fine with $2 trillion in reserves, given how little foreign debt it holds. Others say $2.5 trillion. If reserves are falling by a steady $40 billion a month/$500 billion year, it is only a matter of time before China hits its limit. With China, it may be a long time though… However, there are two reasons why I am not yet convinced that it is only a matter of time before outflows overwhelm the PBOC’s reserves and other exchange rate defenses. First, reserve loss and thus the scale of outflows remains correlated with movements in the yuan against the dollar. In quarters with significant yuan depreciation against the dollar, reserve loss—using the PBOC’s foreign assets as the measure—has varied between $100 billion and $225 billion (q3). In the two quarters during the past year when the yuan was stable or appreciating against the dollar (q2 of 2015 and q2 of 2016) the quarterly reserve loss was very modest—under $20 billion. So if the PBOC was serious—and that might mean losing a bit of face by moving away from the basket peg—and let the yuan strengthen against the dollar, my guess is that outflow pressures would fall significantly. It would help if the PBOC allowed a bit (more) upward drift against the basket—and thus reinforced expectations of two-way risk against the dollar. Remember that the PBOC took advantage of dollar weakness in the first half of 2016 to reset the yuan’s level against the basket. I understand why, but that reset had a price—it reinforced expectations that the yuan only will move one way against the dollar. The second is that a lot of the outflows so far in 2016 have come through channels that I think the State Administration for Foreign Exchange (SAFE) can effectively control, if it was determined to do so. A surprisingly large share of the outflows last year come from balance of payments categories that I think the authorities can control, and can control without too much administrative difficulty, as they ultimately require supervising a relatively small number of accounts at a manageable number of large state institutions (of course there are political difficulties here, but the administrative complexity should be lower). A bit of balance of payments math: China runs a goods surplus of around $500 billion (in BoP terms) annually. And—even with the fall off in FDI inflows—should get another $100-$150 billion in FDI ($250 billion would have been more typical a few years back). So China has over $600 billion/6 percent of GDP in inflows from FDI inflows and the goods trade to finance its services imports (which likely include a lot of hidden outflows through the tourism side), its FDI outflows, and non-FDI outflows, without having to dip into its reserves. Of course, China has dipped into its reserves in 2016. Based on the PBOC balance sheet data, reserve outflows in the balance of payments for 2016 should be about $450 billion (I am assuming a $150 billion fall in reserves in the q4 balance of payments). But I can count outflows of roughly equal size that seem to me relatively easy for the PBOC—really SAFE—to control if they really want to. In 2016, the banks have been adding to their foreign exchange reserves (other foreign assets) at the PBOC at a roughly $25 billion a quarter pace. That slowed in q4, so let’s call it about $75 billion a year in outflows. That easily could be put to an end; the share of the banks regulatory reserves held in foreign exchange is totally determined by the PBOC. In 2016, the build-up of portfolio debt and equity assets abroad—almost certainly by a few state institutions or major financial institutions that the state regulates—has been a bit under $25 billion a quarter. Call it $100 billion a year. China knows how to put a stop to these flows; outflows in these line items were essentially zero from 2010 to 2014. In 2016, overseas lending—long-term loans made by the Chinese state banks to the rest of the world—have averaged a bit over $25 billion a quarter, or $100 billion annualized. These all come from the big state commercial and policy banks. They could be slowed with a bit of regulatory supervision. And FDI outflows have averaged about $60 billion a quarter in the first three quarters (roughly $250 billion annualized). A more normal number—judging from the numbers seen before the devaluation—would be maybe $25 billion a quarter ($100 billion a year). Reducing outflows there back to the norm—as seems likely to happen—might reduce total outflows by $150 billion. Sum up these line items, and that takes away $425 billion in outflows—a sum almost equal to the projected fall in reserves in the balance of payments. And I suspect that if China’s reserves fell by $25 billion a year, no one would care that much (even if such a number implies an ongoing outflow of between $400 and $500 billion, depending on your view of how much of the services deficit is “real”).