Welcome to the Jungle

Welcome to the jungle
We got fun 'n' games
We got everything you want
Honey we know the names
We are the people that can find
Whatever you may need
If you got the money honey
We got your disease

-Guns N' Roses, "Welcome To The Jungle"

Macro Man has no idea if Hank Paulson is a Guns N' Roses fan or not. Still, he cannot help but think that the US Treasury Secretary should enter the forthcoming G7 meeting, WWE-style, with lights flashing and "Welcome To The Jungle" blaring out of strategically-placed loudspeakers. Hell, Macro Man would be willing to grow a mullet and fork out $50 to see it happen.

And why, you may ask, should the US Treasury Secretary make such a histrionic entrance to what is normally a fairly staid summit meeting? Because European policymakers have belatedly realized that China is, for lack of a better phrase, taking the piss with their currency policy, and have at last begun to complain about it. "Welcome to the jungle," Mr. Paulson may feel justified in saying, "and welcome to my world."

To be sure, Europe would also like the US to flesh out the "strong dollar" policy which has been the Treasury's mantra for a dozen years, but such hopes are pretty clearly misplaced. The strong dollar policy has been little more than a zombie for the past few years, exhumed from its grave on occasion but with no real sparkle in its eye. Not that that is necessarily a bad thing; with large external deficits and a slowing economy, it 's not terribly difficult to see how a weaker buck might be a boon to both the US economy and the party currently occupying the White House. Of course, if there ends up being an inflation problem (as seen through the lens of the bond market, rather than Joe Sixpack), then a strong dollar might have some utility- as it did in 1995. For now, though, Macro Man interprets the strong dollar policy as favouring a "strong dollar, as long as it doesn't mean that the dollar goes up."

So why has Europe arrived at the "China, quit screwing around" party? Other than the obvious surge in EUR/USD, which has applied pressure to some (though not all) exporters, the trends in trade with China are rather telling. Updating charts that Macro Man first posted a couple of months ago reveals that a milestone was reached in August. Although China's trade surplus with the US continues to grow, the incremental change is pretty small. Both import and, more importantly, export growth have decelerated.

Compare the picture above with China's trade with Europe. Note how the monthly balance continues to rise sharply, and observe the scale on yearly export growth. China's export growth to Europe has grown nearly three times as fast as its export growth to the US! To be sure, European domestic demand has been a bit higher than in the US over the past year (1.9% versus 1.4%, by Macro Man's calculations), but that clearly doesn't explain such a pronounced gap in China's export growth. Regardless, China's surplus with Europe ($15.3 bio) exceeded its surplus with the US ($15.0 bio) for the first time in August. Maybe, just maybe, currencies actually do matter, as Macro Man and Brad Setser have been arguing.Given trends in trade, capital flows, and good-old-fashioned valuation, EUR/RMB should be dropping. While it is not at the all-time highs observed in late 2004, it has been rising steadily for the past two years-even as China's trade surplus with Europe has exploded. At the same time, Voldemort has been buying euros every month as part of its FX reserve strategy. This year, Macro Man figures they've needed to buy €10-15 billion a month just to maintain portfolio benchmarks. Can there really be much doubt that PBOC is the agent responsible for preventing EUR/RMB from falling?

And so Europe has now entered the same jungle occupied by the United States for a number of years now: saddled with an overvalued exchange rate and seeing external deficits with a strategic trading partner ballooning fast. At the same time, the monetary authorities of that partner fully exercise (and, many would argue, abuse) their right of participation in global markets while restricting participation in their domestic currency, bond, and equity markets to a priviliged few. Is it any wonder that Europe is irritated?

Of course, living in the jungle and thriving in the jungle are two different things. And while G7 may call upon China to quit playing around, they possess neither the carrot nor the stick to force China to do so- at least, not a carrot or stick that they are prepared to use. Indeed, it's not difficult to argue that the most important meeting of the month will be the Party Congress of the Chinese Communist Party.

Macro Man isn't sufficiently conversant with the people involved to comment intelligently on likely outcomes and long-term policy ramifications. What he does know, however, is that the run-up to the Congress has seen something of a policy vacuum, with no one really willing to stick their neck out, lest their head get removed in the process. As such, the prospect for meaningful change in the FX regime would appear be higher after the Plenum than has been the case for the past few months.

That having been said, the base case should probably be for no change, or change at the margin. Gradualism has been the hallmark of the CCP's management of the economy, and it would seem reasonable to expect that to continue. The upshot is that FX reserve accumulation is likely to continue, RMB appreciation versus the dollar is likely to remain frustratingly slow, and the RMB very well might continue to decline against the euro.

Welcome to the jungle, Europe. Grab a seat. You might be here awhile.