Thursday, July 16, 2009

Informal thoughts on China forex and US/China situation

China forex above 2 trillion now; up 180 bill in the three months to June.

All back of napkin estimates but let's parse that a little.
Trade surplus for those three months~$33 Billion. Interest payments on US, EURO, and Japanese bonds~$6-10 billion.
Valuation effects on Euro, Japan, and other assets due to the (on average) 7.5% appreciation of Yen, Euro, etc: $45 billion.

Which leaves us roughly $95 billion of "hot" money; multinationals trading their dollars in for yuan to invest or build capital in China, plus some investors who manage to slip through the cracks.

In other posts I've talked about how asset preference shifts are a major determinant in exchange rates, and this is a wonderful example. As risk aversion subsided, dollars sought opportunities on foreign shores (in this case China) and I'm sure this was responsible for part of the drop in the dollar, in spite of China's currency peg.

So the US is damned if we do damned if we don't. Either we have a strong currency paired with risk aversion, or we have an improving economy paired with a falling dollar. No way around it.

People like to compare US/China situation to Britain/US 100 years ago. They point out that the dollar didn't become reserve currency for 25 years after US became dominant economic player. This comparison leaves much to be desired though. For one thing, US is roughly same land mass as China, is natural resource rich. That would argue that China will not overtake the US as the world leading economic power, much less depose our currency.
We still have the best universities and a tradition like none other of risk taking (which definitely correlates with high economic activity).

On the OTHER hand, we are definitely in a funk, particularly K-12 education; we are in much worse fiscal/debt shape then UK was at the same time; we have a fiat currency; and face potentially serious resource constraints. FWIW, I think all of this research coming out (SF FED for example) pointing to a lower d(potential GDP) is nothing more than a REFLECTION of resource constraints experienced between 2005-2008 (expensive oil as exhibit 1). As usual, the standard interpretation puts the cart in front of the horse and says that the recession is leading to a lower potential GDP. Hogwash. I'm not saying that it isn't an integral part of the mechanism, and I'm sure the granger causality tests are rejected, but it is still putting the cart in front of the horse. The REASON we had the downturn in the first place, and the REASON people switched to feeling quite pessimistic about things stem from resource constraints. Same goes for the credit crisis IMHO, but that is harder to show.

For those that want evidence that the resource constraint could have been responsible for the great recession (with credit channel intermediaries acting only as a delivery mechanism) check out my paper on oil at or any of Hamilton's papers on the same subject. Fits the data very well: much better in fact than the monetary theories.

Any way, I have kind of wandered away from my initial point.

My point is that the US/China situation does not have a good comparison. The US is an awesome country. However, we are hamstrung by debt, and that could create an out-sized setback to our economy if the world experiences meaningful resource constraints over the next decade.

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