A deal to reduce the trade deficit will have far-reaching consequences for the dollar...
In May, China reportedly offered the United States a $200 billion reduction in its goods surplus with the United States. It would be a major victory for the Trump administration’s tough trade policy on China.
The Chinese authorities so far have confirmed they are willing to buy up to $70 billion more agricultural and energy goods from the United States and they would be able to make good on the promise given the centrally-planned Chinese economy.
But even if China were to follow through and import more from the United States or export less to it - reducing its surplus from the $500 billion in 2017 to $300 billion per year in the future - this would not be the end of the story.
The problem with the single-handed focus on trade is that international trade between different nations has two sides. One is the goods trade, the other is the trade in capital, which has far-reaching consequences for interest rates and exchange rates.
So far, the United States has financed persistent deficits in goods with persistent surpluses in capital exports. This means foreigners ship BMW cars and Samsung TVs to the United States and end up owning Miami condominiums, Apple stocks, and U.S. Treasury bonds.
Of course, it’s not necessarily the same people who sell the BMWs and get the Apple stock, but the equation applies to the trade balances between nations.
At the end of 2017, foreigners owned $33.8 trillion of U.S. assets with the United States owning $26 trillion of foreign assets, a net deficit of $7.8 trillion, which represents the accumulated trade deficit with the rest of the world from past decades.
Indeed, capital transactions make up 95 percent of international financial flows, compared to 5 percent for trade.
More importantly, these international investment decisions are not made at a top-down level, although they balance out trade surpluses and deficits automatically at the national aggregate.
Because the United States has a very open capital account (there are few restrictions on money moving in and out of the country) and attractive assets (Apple and Miami), it brings in investments from foreign countries with high savings rates like Germany and China.
Both companies and consumers in these countries save more than they spend because of culture, state intervention, and many other reasons. Either way, companies and individuals make asset allocation decisions independently of the national goods surplus their country has with the United States.
So how does the capital account automatically balance with the trade account? “Over 90 percent of the ‘adjustment’ required to balance the accounts lies in the value of currencies,” writes Woody Brock of research firm Strategic Economic Decisions who wrote an excellent paper on the topic.
Because of relatively inflexible supply chains as well as sticky consumer preferences, it takes large moves in currencies and prices to shift demand for goods either up or down.
Not so with capital. Even small moves in the currency lead to traders and investors buying and selling trillions of assets, but also vice versa, where changing economic conditions at home or abroad lead to more or less appetite for U.S. assets.
Let’s take the reported $200 billion reduction in the trade deficit with China as an example. In this case, sticky U.S. consumer preferences would fall victim to heavy-handed intervention by the Chinese state, and China would export $200 billion less goods to the United States, while producers in China would at first be swamped by more agricultural and energy products than they needed.
Any combination of the two (more exports to China, fewer imports from China) would reduce the trade deficit from the current $500 billion to $300 billion.
What also stays the same is the demand for U.S. dollar assets by Chinese citizens and companies, absent other economic changes or changes in Chinese policies to further control its capital account.
Before the adjustment and at the current exchange rate of 6.41 yuan per dollar, the Chinese are demanding 3.20 trillion yuan worth of dollar assets, or $500 billion.
But after the adjustment, the United States will only supply $300 billion of capital to the Chinese. How to reconcile the difference? The dollar will have to rise to 10.68 yuan in order to supply 3.2 trillion yuan, worth $300 billion, of U.S. capital.
That’s a 66 percent rise in the dollar - which the United States would consider outrageous, since the politicians on this side of the Pacific have been complaining bitterly that the Chinese are artificially undervaluing their currency.
Of course, there will be changes in the asset mix too, as Miami condos will become very expensive for the Chinese, whereas the relative prices of bonds and stocks and their cash flows (interest payments and dividends) as well as upside potentials are not affected by the exchange rate.
In addition, although Chinese now receive less income from exports if they cannot find a substitute market, this does not mean their demand for foreign capital needs to decline. The Chinese pool of yuan savings is so large that even less income through trade would not make a dent in the appetite for overseas assets.
According to surveys conducted by the Financial Times in China, wealthy Chinese want to invest around 30 percent of their assets abroad, with the United States being the preferred destination. Right now, Credit Suisse estimates Chinese household wealth to be in the region of $29 trillion. And this does not include Chinese companies who are buying everything from foreign companies that fit their strategic needs just to get money out of the country.
It’s important to note that this analysis is only mathematically valid in a two-nation world economy. If other trading partners were involved, U.S. consumers could source products from other countries, the global U.S. trade deficit would not be reduced as much, and the yuan would not fall as much.
However, considering the Trump administration wants to reduce the global trade deficit, the analysis becomes valid again, although it is impossible to calculate the impact on all different exchange rate. The only conclusion: If asset allocation preferences around the world don’t shift and the trade deficit with the rest of the world goes down, the dollar would go up. By how much against which rate is impossible to say.
In the two nation world economy case, the adjustment would wreak havoc with the Chinese regime’s careful plans to centrally manage its currency, which is the biggest reason the Chinese would want to test the waters first with a $70 billion increase in imports and a corresponding reduction in the trade surplus.
Even in the multilateral word economy scenario, adjustments would take time and exchange rate volatility would increase, although the effects would wear off eventually.
Interestingly enough, tariffs on Chinese goods would lead to a much similar result. They make Chinese goods more expensive in dollar terms and represent an artificial devaluation in the U.S. dollar. They would thus reduce the trade deficit by limiting Chinese exports to the United States.
What they would not do is limit the amount of capital demanded by the Chinese for U.S. assets. And unless the tariff also includes a surcharge on Chinese investment in the United States (an artificial boost to the U.S. dollar), we would be confronted with similar exchange rate dynamics as in the example above.
In either case, absent significant changes in U.S. industrial policy and capital goods accumulation, the currency is the only variable to make the United States better off on world markets both from a production and a consumption perspective.
The deal won’t boost U.S. exports and industrial production, but the trade deficit will be reduced and U.S. consumers would get more bang for their buck. So as unlikely as the full $200 billion reduction is about to happen, from a U.S. perspective it may be worthwhile.