Curious Case of US Deficit: Life of Excesses

In my Curious Case Series i will be discussing about US trade deficit and why US is responsible for  its own trade deficit and not China or any other country.

I start my blog today to explain a key concept in macroeconomics by examining equation of National Savings..

S-I=NX=National Savings.  ( S=Savings, I=Investment, NX= Trade Balance).This is applicable for an open economy since for closed economy S=I. This equation signifies that  trade surplus is due to savings over investment. The for US trade deficit is not becuase of China but because Americans do not save living a life of excesses. President Obama has been one of the best Presidents in US and i greatly admire him since he believes in peace and brought down US participation in needless wars thanks to George Bush. However President Obama did not tell his citizens that the key problem facing Americans is their very low savings rate.

Source: Wikipedia
Although the savings rate is better now as compared to 2008, it is eerily coming down and compared to China which is approx. 51% and India around 32% , USis dismissal low. Although higher savings rate is good but too high in case of both China and India is not good since savings should be invested in capital markets like equity markets and this is why the retail equity participation  is low in both the countries.   Moreover the corporate leverage in US has become government leverage due to excessive quantitative easing.

Source: Market Realist

Quantitative Easing

The asset size of FED is around about USD4.5 tr is due to QE. Quantitative Easing is program through which FED increases money in the system. It is a open market operation wherein FED buys treasuries and mortgage backed securities from corporates like banks, pension funds, insurance companies etc and increases the liquidity in the system by circulating money. QE is done when nominal interest rates are zero and the central bank cannot reduce rates further so it makes it increases the liquidity in the system and makes interest rates negative. This is done so that in a recession banks and asset managers can lend money to corporates and households to boost consumption…

QE certainly did help avoid  a prolonged longer recession ( thanks in part to Ben Bernanke whose thesis in PHD was great depression of 1929)  but it has been it has used for a longer time with interest rates between 0-0.25% driving excessive liquidity again in the system.  If you remember the credit crisis was caused due to excess liquidity in the system: Alan Greenspan two major oversights ( keeping the interest rates low due to 2000 Tech crises/ September 11 attacks and failure to regulate the mortgage market )

And the cycle is repeating again: Although it is not clear how much did QE boost US consumption but it has taken asset classes like bond market, equity markets to astronomical levels.  In end we might be on the tip of another crises which is surely in US Bond market or S&P 500 which is now at all time high.

After the credit crisis Americans should have changed their behaviour and learnt that in economics there is no free lunch..But US is getting away due to its reserve currency status…We will come to it later

US politicians blame China and other economies for trade deficit is unjustified since today it is China which is the largest exporter to US, tomorrow it will another country which will  make cheaper products and cause trade deficit. Moreover Chinese products will slowly get more expensive as the wage growth keeps pace with growth in GDP and productivity and hence will make the products more expensive. A report by WSJ has already stated that BCG has estimated that the labour cost is 5% below US and by 2018 it will be cheaper to produce in US. China should of course focus on making world class brands and increase consumption. Refer to this article below.

http://www.ibtimes.com/chinas-exporters-hope-boost-yuan-devaluation-analysts-say-it-wont-solve-systemic-2050763. 

Yuan Devaluation….

Again the markets have overreacted to Yuan devaluation by only 1.9% which we will see China is justified in doing so. ( Actually IMF welcomes the devaluation as it feels it will allow market forces to greater role in determining the exchange rate.. refer to fig below on yuan).  Renminbi follows a crawler peg to the dollar over the last few years and for the last 20 years China has not intervened in the currency markets. Recent article on Bloomberg has correctly stated that  dollar ( which has been one of the best performing currency in the world) has caused Yuan to appreciate against other currencies. IMF had recently announced that the Yuan is fairly valued  and the recent one off devaluation is at best a correction in the overvalued Yuan. Recent data from the Bank for International Settlements, the Basel-based central bank for central banks, indicated the yuan had become the second-strongest major global currency in the world after the Swiss franc. It calculated that the yuan had risen 26% to June from 2010, according to a measure called the real effective exchange rate which measures its strength against a basket of other major currencies. (Source:http://www.wsj.com/articles/yuan-devaluation-enters-debate-on-whether-currency-is-undervalued-1439307298).

Therefore China has done the right thing in devaluing the currency and a 1.9% is a very small devaluation and as stated by Central bank as one time devaluation.

Inclusion in SDR

China deserves to be included in the basket of reserve currencies called SDR since it is by far the most dominant economy in the last few years. ( Refer my article Curious Case of Chinese Equity Markets). Most important China has made a huge progress  in internationalising its currency.

Look at the chart below 

Source: Bloomberg.com

Moreover Yuan trades in offshore market as CNH in Hong Kong which closely tracks CHY in Mainland China. China also like India helps investors to hedge Yuan by playing in Non Deliverable Forwards Market. China cannot allow Yuan to be free float too soon since the currency market is dominated by speculators and hedge funds and they would drive up Yuan to unreasonable limits. Moreover lately Yuan is more defined by markets than government interference. Look back into history “Plaza Accord “which was one of the prime reasons for Japanese collapse ( appreciated Yen  to a very high level against the dollar).

US is worried that China might replace it as a reserve currency and hence it is trying to delay China’s entry in SDR.

This is really wrong on two parts. First, dollar should be one of the worst currencies due to huge budget deficit and debt to GDP ratio. Dollar being the reserve currency is making Americans have free lunch for their excesses since countries have to buy US treasuries and this makes the dollar stronger apart from that energy especially oil is still bought in dollars. Many reasons for Dollar to be the reserve currency ( one among many is petro dollars). China this year has become the largest importer of energy so it is now more influential compared to US in middle east. Going back to 2008 crises it was China which bought US treasuries and helped stabilize Dollar when the world was collapsing around US. China still holds the largest amount of US treasuries if i am not mistaken..

Second, US corporations make handsome profits by outsourcing work in China. Apple assembles phones in China for USD 300 and sells for USD 900 which in turn has increased the competitiveness of US firms and build huge cash reserves. As a matter of fact Yuan is today one of the most tradeable currencies worldwide. Today China invests more in US real estate ( overtaking Canada) shows Chinese people believe in internationalization of Yuan since it is an outward flow of capital by investing in US dollars…..

If you look over the last two decades most of the crises has come from US right from LTCM crises, Tech Bubble and Credit crises which resulted in countless jobs lost ( which also affected by employment). US has to understand that both US and the whole world will benefit as China rises. China rise will ultimately try to balance  power between US and China since power tends to corrupt and absolute power corrupts absolutely. China’s rise will ultimately lead to better economically resource allocation as well as more technological breakthrough which will lead to healthy competition and lower prices for customers.

Going forward, Yuan should be included as a reserve currency in SDR..

I hope Americans can learn a lesson of their past mistakes especially since they owe China. As a matter of fact the world owes to China in the last few years and otherwise we would have had a very deep global recession. US leads in innovation, has world class education and ability to attract the best talent,was formed on a very holistic principle of equality for all………………………………..,.

As the number one economy US should lead by an example: propagate peace, economic progress and well being among all the countries…………………………..

Nishant also known as Nish can be followed on his Facebook https://www.facebook.com/nish2worldpeace.

Nishant is passionate about global peace and economic growth 

Afternote: Professor Robert Shiller’s cyclically adjusted price earnings ratio — or Shiller CAPE — for the S&P 500 stands at 27.2, some 64 per cent above its historic average of 16.6. On only three occasions since 1882 has it been higher — in 1929, 2000 and 2007. Please refer to news.. S&P 500 is a bubble. I had published this article on LinkedIn on 13 August about the bubble in S&P 500 and US equities.The S&P 500 has fallen more than 5% in last 5 days…..Well more has to come..I made a timely prediction..

I did not mention about Triffin Dilemma an economic theory which describes the basic differences in the objective of a country with reserve currency leading to imbalances in current account. Further you could read more about the topic in a paper by Dr. Zhou Xiaochuan, an eminent economist and the present governor of China who suggested moving into SDR as a global currency ( based on Keynesian concept of Bancor)

Coming up part 2 of this article..Learn something