Title: GLOBAL IMBALANCES ARE JUST A FORM OF VENDOR FINANCE   
                
Date Posted: 27/01/12

Comment: For decade after decade, whenever some unfortunate Third World country got behind on its payments, US and European governments would take the moral high ground, lecturing the delinquent country on fiscal prudence, warning it of the evil consequences of over-borrowing, and telling it to cut spending and raise taxes so that it could repay its lenders. (The lenders were usually US and European banks.) If the misbehaving country didn’t clean up its act quickly enough, then the Western countries would send in their pit bull, the IMF, to enforce good behaviour.

Since the GFC, the shoe has been on the other foot. The Chinese government frequently gives itself the pleasure of lecturing the US on fiscal prudence, telling the US to behave itself or else China might pull its money out of the US and put it into a more responsible country.

Enjoyable though this lecturing may be, the Chinese government knows perfectly well that for the time being it has no alternative to the US. Its USD 3 trillion worth of foreign exchange reserves are simply too big to place in any other currency or any other economy. At best China might start putting its new inflows into more diverse places. But China can’t suddenly ditch its US dollar assets, because any attempt at a sizeable sell-down would set off a run on the US dollar, reducing the value of China’s remaining holdings.

Apart from the practical question of where to invest China’s forex reserves, there is a fundamental reason why China needs the US to keep running deficits on its balance of trade. China may well be manipulating its exchange rate in order to keep its exports cheap, but it is also providing vendor finance for its biggest customer. Like any other form of finance, vendor finance has to be repaid (or written off).

The Chinese government has been accumulating forex reserves for the last decade because it wanted to keep the yuan low against the US dollar. To do this, whenever a Chinese exporter sold some goods to a US retailer and received US dollars, the Chinese government had to buy the US dollars, paying the exporter in yuan. If it didn’t do this, there would be more and more US dollars relative to the number of yuan, so the US dollar would tend to fall against the yuan, making Chinese exports more expensive.

This policy had two outcomes which couldn’t be sustained indefinitely: first, the Chinese government kept on adding to its holdings of US dollars and, second, export success encouraged Chinese exporters to invest in more and more capacity. China had to do something with all the US dollars it got from its biggest customer: most of them were invested in US government and semi-government debt. This helped the US government finance its deficits, and the deficits helped the US consumer keep spending, and some of the consumer spending went into buying more Chinese goods.

So the policy of keeping the yuan low not only made Chinese exports cheaper, it also recycled the money to pay for the continued consumer spending by China’s biggest customer. For every trade surplus there has to be a trade deficit.

The same logic is true for Germany and its perpetual trade surplus against the rest of the world. But there’s an important difference: Germany prices its exports in the Euro, and the exchange rate of the Euro doesn’t depend entirely on the success of German exporters. It also depends on the lack of success of exporters in Greece, Portugal and other countries with persistent trade deficits. This means that the Greeks and Portuguese, by keeping the Euro cheap, are helping German exporters to stay competitive.

For both China and Germany, the second policy outcome has awkward consequences. The more money you make from exporting, the more money you re-invest in exporting. After a decade of artificially low exchange rates, both China and Germany have over-invested in their export industries to the point where a lot of the capacity could not exist without artificially low exchange rates. The most obvious example of this “problem of success” is Japan, which had to shut down whole industries in the 1980s after the rising yen made them uneconomic.

When Chinese politicians lecture Americans, or the German politicians lecture Greeks, they’re forgetting that the need to restructure cuts both ways. Just as the spendthrift consumers will have to trim their extravagance, the successful exporters will eventually have to shut down much of their export capacity and shift their economies toward internal consumption.


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