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.

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Anonymous
admin
October 9, 2007 at 1:40 PM ×

Macroman -- I presume you are using chinese trade data to prepare these charts (i.e. accepting the "Hong Kong" distortion).

the picture showing the rise in china's surplus with europe is great.

would take issue slightly with your argument that china alone is keeping the eur up; sure, it sells a lot of $ for euros, but without its far larger increase in $ holdings, the US deficit wouldn't be close to financed.

bsetser

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Macro Man
admin
October 9, 2007 at 1:46 PM ×

Brad, yeah this is from China's own dataset. Note though that I say China responsible for EUR/RMB...while they may not be fully responsible for EUR strength, they sure as shinola are responsible for RMB weakness!!!!

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Agustin
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October 9, 2007 at 2:59 PM ×

"Welcome to the jungle, Europe". Very true. In fact, the ECB finds itself in a situation that is not unlike the one faced by the Fed 10 years ago. When you manage a world reserve currency, domestic monetary indicators may be distorted by "flight-to-quality" episodes ocurring in faraway places where your currency backs the monetary base. It ain't the old Bundesbank any more. The ECB's current dilema: how to ease policy to prevent a slowdown, even as M3 surges forward? Cheers.

Agustin Mackinlay at www.liquidityblog.blogspot.com. (By the way, Argentina did beat Ireland by 15 points. Bring on the Springboks).

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Macro Man
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October 9, 2007 at 3:08 PM ×

Yes, I see that you have addressed this issue as well, Agustin. One of the historic hallmarks of reserve currencies is that they are expensive, since people buy them for their perceived "intrinsic value" rather than the goods and services that can be purchased with it. Of course, part of that instrinsic value is the breadth and depth of available financial assets.

But Europe hasn't had to deal with a currency that is this strong for this long since the early 90's....and we know that that ended rather badly. Kind of like Ireland's World Cup campaign, actually...

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David Pearson
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October 9, 2007 at 5:10 PM ×

Macro Man,

Thoughts on whether Chinese food inflation will be an issue for the CCP? In the past, they've just HATED IT when people rioted over food prices. Sure they're not rioting now (that we know or hear of), but given the acceleration in prices, can it be far off?

Of course, food price inflation is a direct consequence of reserve building.

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Anonymous
admin
October 9, 2007 at 5:39 PM ×

Great column today, as usual.

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"Cassandra"
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October 9, 2007 at 6:11 PM ×

MM, Brad,

Europe never had a true-blue (red surely!) consumption bubble based on credit before , mostly because no one really ever offered it to them, the people, directly before. War(s), inflation, war, taxes, energy shocks, inflation (and the memory thereof) yielded generations of relatively stoic parsimonious behaviour.

But just look at the Brits! Inside every stoic is a crass consumer just waiting for the opportunity, finance (and low prices!) to break free. OK, maybe not the Norwegians, but we are witnessing a fascinating economic experiment of an entire continent being offered what by all accounts is a veritable free-lunch, or at least one seeming yet unseen generosity in respect of exchange terms of trade, and rates & conditions of finance. Maybe it will prove to be a proverbial poisoned chalice. Maybe authorities, well-read in Macchiavelli will counter with trade and industrial counter-measures that prevent the most egregious employment and wage effects of predatory mercantile policies. Or maybe, they'll do like the Americans and gorge themselves on the smorgesbord until they can eat no more, and all their remaining factories have all been transplanted eastward ho!

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Macro Man
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October 9, 2007 at 7:08 PM ×

David, I do indeed think food inflation is a pressing issue for the CCP, and the one most likely to encourage a change in the current policy regime. I wrote about it not that long ago, as a matter of fact.

C, while I don't have the numbers in front of me, I certainly don't think that the percon figures in Europe suggest an imminent consumption orgy. (The UK is the obvious exception, as it has displayed a prominent predilection to consume since the advent of the coke-snorting, Porsche-driving wideboys of the Big Bang era.)

That having been said, Europe has seen its international relative purchasing power zoom higher, though commodity prices may put paid to any sense of windfall riches.

As I noted on Brad's blog this afternoon, Europe's entry in to the "hey, quit taking the piss" camp brings us one step closer to protectionist hell....

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"Cassandra"
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October 9, 2007 at 7:32 PM ×

I concur (and have maintained since 2003) that flagrant and bombastic protectionism has always been the endgame of benign (and not so benign) neglect of policymakers not heading off at the pass what what the market unfettered will do, until it can do, no longer.

THAT said, drinking the elixir of consumption with the benefits of an overvalued currency and easy credit has most powerful and intoxicating effects. So continentals ARE used to being abused in the name of their own interest, but having drunk from the cup, they may this time scream louder than the counter-protestations of unelected commissioners and Josey Bovey

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