Most Favoured Nation: Area Man Says "It Depends"
Guest post by Karthik Sankaran
This is the second post by Karthik Sankaran, who has agreed to occasionally write for MFN on big macro issues that impact international trade and the global economy. Karthik has, at various times, been a modern historian, emerging markets journalist, and global macro portfolio manager and strategist. He is also an incorrigible and prolific source of terrible puns. I hope this provides an informative reprieve from my usual warbling on about niche technical issues and a more global context.
If you like what you read, please do sign up to Karthik’s Substack, which he promises to populate with more content soon. Meanwhile, he can also be found procrastinating on Twitter as @RajaKorman.
One common interaction in online economics discussion involves some hapless journalist or publication saying that China has contributed X% to global growth, followed by angry rejoinders that by running large trade surpluses, China is actually subtracting from growth in the rest of the world because its exports replace domestically produced goods elsewhere more than its imports support other economies.
While this is true as an accounting identity, it is also little more than a truism. And the reason is that growth patterns and economic outcomes in one country spill over into the rest of the world through many more channels than trade alone. Helpfully, this web of influences has now become a noun in standard economic commentary —the ‘spillover’.
Large economies influence growth beyond their borders not just through the simple arithmetic of trade balances but also through a range of financial channels. This includes, among other things, their impact on global interest rates, currencies, and commodity prices, each of which can affect economic activity as much as — and often more than — an excess of exports over imports in displacing domestic production elsewhere.
Market commentators do seem to recognise this about the US in particular—it is generally acknowledged that high US interest rates and dollar strength can lead to a substantial tightening of global financing conditions because the US currency is the predominant denomination for both cross-border invoicing (particularly for commodities) and cross-border borrowing. The combination of high interest rates and dollar strength can heighten financial distress in commodity-exporting emerging markets that typically have a greater portion of their debt denominated in dollars.
The classic example is the Reagan-Volcker shock of the early 1980s. As is well known, the US trade deficit expanded dramatically in the period, reflecting both a tax-cut-driven boom (albeit after a brutal recession) and runaway dollar strength. But while US appetite for imports eventually helped Western Europe and Japan (commodity-importing industrial economies largely indebted in their own currency), the combined impact of high US interest rates and dollar strength helped tip developing economies in South America and Eastern Europe into serial financial crises, from which some of them are yet to emerge.
And it can get even more complicated than that. The US impact on the world is not just about its trade balance (where goods imports can support production elsewhere) or even the worldwide turbulence occasioned by moves in the dollar and US interest rates.
One of the most consequential shifts in the global economy over the past decade has been the US shale revolution. This not only brought the US closer to self-sufficiency in energy but also put downward pressures on global oil prices. Shale helped the US recover from the 2008 financial crisis without undergoing a substantial widening of its aggregate trade deficit — something that hadn’t happened since the 1970s. Outside the US, the fall in oil prices benefited large oil importers in Europe, Japan, and emerging Asia, easing pressures on their trade balance and on imported inflation. Falling headline inflation made space for the ECB to start quantitive easing and allowed many developing countries like India and Indonesia to withdraw fiscally expensive energy subsidies without causing undue hardship. Needless to say, the drop in oil prices was not painless—oil exporters found themselves on the wrong side of a shock in their terms of trade (the relative price of their export and import baskets)—and forced into devaluations, as happened with Nigeria.
Following from the above exposition, I would suggest that for all the indignation lobbed at China as a persistent leech on global demand (which it undoubtedly benefits from), it might make sense to look at the other ways beyond just the simple trade balance that China affects the world. Here, too, it makes sense to consider China’s impact beyond its borders not just through the goods balance but through a broader accounting of terms of trade (the relative price of exports and imports), exchange rates, interest rates, and broader financing conditions.
The early 2000s were famous for large US trade deficits — at about 6% of GDP, they were twice as large as what was considered alarming in 1984-85. They were also the peak years of the infamous “China Shock” that led to significant geographically concentrated job losses in areas focused on mid-tier manufacturing. But the employment shock was most damaging precisely where (and because) it was concentrated, and the overall impact on jobs across the US was more one of geographic (interior to coast) and sectoral (manufacturing to services/nontradeables) reshuffling.
Spillovers from China in other parts of the world were less severe than in the US —large exporters of sophisticated capital goods such as Germany, Japan, Korea, and France did well overall, and Chinese demand boosted global commodity prices, a boon for exporters. Critically, unlike in the early 1980s, outsize US trade deficits were accompanied by a weak dollar, not a strong one, and reserve accumulation in Asia (with China leading) helped hold down global benchmark long rates.1 High commodity prices and easy global financial conditions helped turn Brazil’s balance of trade around and created room for rate cuts and fiscal space for incoming President Lula’s spending programs.
I also have a more controversial take on recent developments. If one thinks that the shale revolution was a positive supply shock that benefited the global economy in aggregate, even at the expense of incumbent exporters, then China’s rapid ascent in producing technologically advanced capital goods at lower prices should look similar. Like shale, it is a terms of trade shock that benefits importers (who outnumber incumbent exporters).
There are obviously immense political and (potentially) geopolitical difficulties that follow from this, but it seems to me consistent with the logic of spillovers laid out above. Further, one of the aggregate macroeconomic effects of an influx of cheap tradable goods in a large, relatively-closed economy should be an increase in real incomes available to spend on non-tradable goods. One factor that may determine whether this leads to an actual improvement in living standards is whether non-tradable supply expands sufficiently to meet such increased demand. Yes, Anglosphere housing markets, I’m looking at you.
But even beyond that, countries with consistent excess of exports over imports typically don’t just hoard the proceeds of their surpluses. They invest them, usually by buying something overseas, which in the modern fiat currency world is mostly the financial liabilities of other countries — though some money might be allocated to commodity stockpiles. The acquisition of such financial liabilities often funds new activities—it could be the construction of second homes in Las Vegas or the Canary Islands (though it might also have been another runway at La Guardia or Heathrow); or a railroad line from Nairobi to Mombasa. The point is that the accusation of consumption foregone at one side of the trade balance arithmetic frequently has its counterpart, an increase in investment on the other side (or in a third place).
The impact on global growth and welfare now and in the future will be a function of i) the quality of a trade surplus country’s overseas investment and the multipliers over time versus a counterfactual of more consumption or investment at home ii) the mechanisms to distribute the losses if the investment goes bad, and the consequences for growth of such a distribution.
My personal belief is that the second issue (loss distribution) has typically been much more problematic than the first for global growth and equity than the first. And, of course, this is a topic that has become more contentious because of differences between China and other bilateral and multilateral creditors over restructuring terms, opacity of lending etc. But South America’s lost decades from the 1980s are a reminder that the growth hit from disputes over burden-sharing long precede China’s ascent. (One dark joke I have made before is that I’m old enough to remember when Communism was associated with subjecting domestic creditors to a process of liquidation, rather than doing the same to overseas debtors).
I think the first issue — the relative merits of domestic consumption versus overseas investment — is more complicated. This is precisely because it seems very clear to me that massive welfare gains could come from boosting consumption in China by increasing education and health spending in particular —this is a country where a good part of the growth impetus in coming years has to come from internal convergence.
Equally, there are large parts of the world that are capital-constrained, and tied project funding from a country that has had a lot of experience in building out capital-goods-intensive logistics and infrastructure makes sense. Particularly since, with the exception of Japan in parts of Asia, no one else seems to have been particularly inclined to provide much of this in Africa, Central Asia, or Latin America, until China arrived on the scene.
Conversely (and I admit this is a reductio-ad-absurdum argument), it would be perverse to argue that it would been have been better for Saudi Arabia to pay half a billion dollars to Lionel Messi to come play football there (intermediate good import boosting domestic consumption) rather than investing that in a new green hydrogen plant somewhere. Yes, I am aware that they invested in WeWork, but still… my point is that this is a question that does not always lend itself to easy moralising on the basis of accounting identities.
To sum up, when I’m thinking about trade balances and the larger patterns of interactions between different economies, and I’m pondering the question “is this good or bad” I can’t help but answer “it depends.”
I guess that’s a personal twist on Dependency Theory.