Even though economists have tools to predict a financial crisis, getting the timing right is not possible
Everyone, from the queen of England to laid-off Detroit autoworkers, wants to know why more experts did not see the financial crisis coming. It is an awkward question. How can policymakers be so certain that financial catastrophe will not soon recur when they seemed to have no idea that such a crisis would happen in the first place?
The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.
For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero.
But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless. And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable.
If the trajectory is unsustainable, how long can debt keep piling up? We do not know. Academic economists have developed useful tools to predict which economies are most vulnerable to a financial crisis. But, although we can identify vulnerabilities, getting the timing right is virtually impossible.
Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning. It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible.
A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities. Yet, high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be low-risk are also vulnerable to heart attacks. Of course, careful monitoring yields potentially useful information for preventing heart attacks.
The same is true for financial systems. Good monitoring yields information that is helpful only if there is a response. Unfortunately, we live in a world where the political and regulatory system is often very weak and shortsighted.
Indeed, no economy is immune to financial crises, no matter how much investors and leaders try to convince themselves otherwise. Right now, the latest “this time is different” folly is that ‘because governments are taking all the debt on their shoulders, the rest of us don’t have to worry’.
We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the US, for example, inflated down its debt significantly in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s.
For now, the good news is that the crisis will be contained as long as government credit holds up. The bad news is that the rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years.
Most worrisome is America’s huge dependence on foreign borrowing, particularly from China. Asians recognise that if they continue to accumulate paper debt, they risk the same fate that Europeans suffered three decades ago, when they piled up US debt that was dramatically melted down through inflation.
The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. The unwinding of unsustainable government deficit levels is a key question that G20 leaders must ask themselves when they meet in Pittsburgh later this month. Otherwise, Queen Elizabeth II and Detroit autoworkers will be asking again, all too soon, why no one saw it coming.
Sunday, September 13, 2009
Friday, September 11, 2009
The incredible shrinking surplus
Is China deliberately understating the size of its trade surplus?
CHINA’S current-account surplus is seen by some as the root cause of the financial crisis. The good news is that after widening year after year it is now shrinking much faster than expected. In the first half of this year the surplus narrowed to $130 billion, one-third lower than a year earlier, and barely half its level in the second half of 2008. Not only has China’s merchandise trade surplus narrowed, but investment income from China’s stash of foreign reserves has also dropped. Arthur Kroeber at Dragonomics, an economic-research firm, predicts that the current-account surplus is likely to drop to 5% of China’s GDP this year, down from 11% at its peak in 2007. Belatedly, China seems to be doing its bit to re-balance the world economy.
But how accurate are China’s figures? In theory China’s trade surplus with America should match the deficit that America reports in its trade with China. The government in Beijing claims that its surplus with America fell to $62 billion in the six months to June. Yet official statistics from Washington, DC, show that America ran a deficit with China of $103 billion during the same period. There are similar disparities with other trading partners. China’s reported surplus with the euro area is only half as big as the number published by European statistical offices. Even more striking is its trade balance with Japan: China says it had a deficit with Japan in the first half of this year, but Japanese data show instead that Japan ran a deficit with China.
China’s economic statistics are notoriously dodgy. Components of GDP do not add up; the sum of provincial GDP is always much bigger than the national figure. It would appear that China’s trade figures are no better. Moreover, the discrepancy is consistently in one direction: China reports smaller bilateral trade surpluses than those suggested by its trading partners’ data. If you add up all countries’ trade with China (using the IMF’s Direction of Trade Statistics database), then the world ran a trade deficit with China of about $650 billion in 2008, more than twice as large as the $295 billion surplus logged by China itself (see chart, left-hand side). That $350 billion difference was nearly four times as big as the gap ten years earlier. Is China running a large trade deficit with Mars? Or, as conspiracy theorists conclude, is Beijing deliberately understating its embarrassingly large surplus?
In fact there are rather less sinister explanations for much of the discrepancy between China’s numbers and those of its trading partners. The most important is that a lot of China’s trade is shipped through Hong Kong. It is often difficult for China’s statistical agency to track the final destination of such exports, so goods which are exported from China to Hong Kong and then re-exported to America, say, are usually recorded by officials on the mainland as exports to Hong Kong. By contrast, it is easier for customs officials in importing countries to determine the true country of origin, so America correctly records these same goods as imports from China. Likewise, America’s exports to China which go via Hong Kong may be recorded as exports to Hong Kong, while China will count them as imports from America.
Hong Kong re-exporters also add a mark-up of around 25% to goods they handle, which drives a further wedge between the value of China’s exports and their import value at their destination. The result is that official statistics overstate the true size of America’s and others’ deficit with China, while Chinese statistics understate its surplus. If re-exports from Hong Kong are included in China’s exports to America, the gap between the trade figures reported by China and by America is reduced by about half (see chart, right-hand side). This still leaves a big shortfall, however, and it does not explain why China’s global trade surplus (which includes all trade with Hong Kong) is so much lower than the sum of bilateral trade balances reported by the rest of the world.
Balance cheat?
Another factor is that countries report exports and imports on a “customs” basis. Imports include the cost of insurance and freight but exports are recorded on a “free on board” (FOB) basis, which excludes such charges. An importer will always show the value of goods to be 5-6% more when they arrive than when they left the exporting country. If all shipping costs were excluded from the sums, China’s surplus would be bigger but its trading partners’ deficits would be smaller. Indeed, China’s government does report its trade surplus with imports on an FOB basis as part of its half-yearly balance-of-payments accounts. In 2008 it was $360 billion, $65 billion larger than on a customs basis.
A study in 2007 by America’s Treasury adjusted China’s trade with over 100 countries to include re-exports through Hong Kong and exclude shipping and insurance as well as the mark-up charged by Hong Kong re-exporters. This increased China’s trade surplus in 2005 by $75 billion and reduced the sum of deficits reported by the rest of the world by $140 billion, so the discrepancy between the two figures fell from over $300 billion to $90 billion.
Much of the remaining gap probably reflects disguised capital flows rather than a deliberate ploy by Beijing to understate its trade surplus. In order to dodge capital controls and move money out of China, firms declare exports at less than their true value, or imports at more. Firms also use such wheezes to transfer profits to affiliated firms in low-tax areas, such as Hong Kong. The money then comes back to China as foreign direct investment to take advantage of more favourable tax treatment. Such disguised outflows are unlikely to be increasing, however. If anything, given that China is bouncing back faster than the rest of the world, exporters have more of an incentive to over-invoice exports as a way of bringing foreign money into the country. This suggests that the country’s trade surplus is declining as rapidly as it claims.
China’s trade surplus—and hence its current-account surplus—is almost certainly bigger than that reported by Beijing, even if it is much smaller than the combined deficits reported by America and other trading partners. But for the rest of the global economy, the crucial thing is not the precise size of China’s surplus, but the fact that it is finally shrinking.
CHINA’S current-account surplus is seen by some as the root cause of the financial crisis. The good news is that after widening year after year it is now shrinking much faster than expected. In the first half of this year the surplus narrowed to $130 billion, one-third lower than a year earlier, and barely half its level in the second half of 2008. Not only has China’s merchandise trade surplus narrowed, but investment income from China’s stash of foreign reserves has also dropped. Arthur Kroeber at Dragonomics, an economic-research firm, predicts that the current-account surplus is likely to drop to 5% of China’s GDP this year, down from 11% at its peak in 2007. Belatedly, China seems to be doing its bit to re-balance the world economy.
But how accurate are China’s figures? In theory China’s trade surplus with America should match the deficit that America reports in its trade with China. The government in Beijing claims that its surplus with America fell to $62 billion in the six months to June. Yet official statistics from Washington, DC, show that America ran a deficit with China of $103 billion during the same period. There are similar disparities with other trading partners. China’s reported surplus with the euro area is only half as big as the number published by European statistical offices. Even more striking is its trade balance with Japan: China says it had a deficit with Japan in the first half of this year, but Japanese data show instead that Japan ran a deficit with China.
China’s economic statistics are notoriously dodgy. Components of GDP do not add up; the sum of provincial GDP is always much bigger than the national figure. It would appear that China’s trade figures are no better. Moreover, the discrepancy is consistently in one direction: China reports smaller bilateral trade surpluses than those suggested by its trading partners’ data. If you add up all countries’ trade with China (using the IMF’s Direction of Trade Statistics database), then the world ran a trade deficit with China of about $650 billion in 2008, more than twice as large as the $295 billion surplus logged by China itself (see chart, left-hand side). That $350 billion difference was nearly four times as big as the gap ten years earlier. Is China running a large trade deficit with Mars? Or, as conspiracy theorists conclude, is Beijing deliberately understating its embarrassingly large surplus?
In fact there are rather less sinister explanations for much of the discrepancy between China’s numbers and those of its trading partners. The most important is that a lot of China’s trade is shipped through Hong Kong. It is often difficult for China’s statistical agency to track the final destination of such exports, so goods which are exported from China to Hong Kong and then re-exported to America, say, are usually recorded by officials on the mainland as exports to Hong Kong. By contrast, it is easier for customs officials in importing countries to determine the true country of origin, so America correctly records these same goods as imports from China. Likewise, America’s exports to China which go via Hong Kong may be recorded as exports to Hong Kong, while China will count them as imports from America.
Hong Kong re-exporters also add a mark-up of around 25% to goods they handle, which drives a further wedge between the value of China’s exports and their import value at their destination. The result is that official statistics overstate the true size of America’s and others’ deficit with China, while Chinese statistics understate its surplus. If re-exports from Hong Kong are included in China’s exports to America, the gap between the trade figures reported by China and by America is reduced by about half (see chart, right-hand side). This still leaves a big shortfall, however, and it does not explain why China’s global trade surplus (which includes all trade with Hong Kong) is so much lower than the sum of bilateral trade balances reported by the rest of the world.
Balance cheat?
Another factor is that countries report exports and imports on a “customs” basis. Imports include the cost of insurance and freight but exports are recorded on a “free on board” (FOB) basis, which excludes such charges. An importer will always show the value of goods to be 5-6% more when they arrive than when they left the exporting country. If all shipping costs were excluded from the sums, China’s surplus would be bigger but its trading partners’ deficits would be smaller. Indeed, China’s government does report its trade surplus with imports on an FOB basis as part of its half-yearly balance-of-payments accounts. In 2008 it was $360 billion, $65 billion larger than on a customs basis.
A study in 2007 by America’s Treasury adjusted China’s trade with over 100 countries to include re-exports through Hong Kong and exclude shipping and insurance as well as the mark-up charged by Hong Kong re-exporters. This increased China’s trade surplus in 2005 by $75 billion and reduced the sum of deficits reported by the rest of the world by $140 billion, so the discrepancy between the two figures fell from over $300 billion to $90 billion.
Much of the remaining gap probably reflects disguised capital flows rather than a deliberate ploy by Beijing to understate its trade surplus. In order to dodge capital controls and move money out of China, firms declare exports at less than their true value, or imports at more. Firms also use such wheezes to transfer profits to affiliated firms in low-tax areas, such as Hong Kong. The money then comes back to China as foreign direct investment to take advantage of more favourable tax treatment. Such disguised outflows are unlikely to be increasing, however. If anything, given that China is bouncing back faster than the rest of the world, exporters have more of an incentive to over-invoice exports as a way of bringing foreign money into the country. This suggests that the country’s trade surplus is declining as rapidly as it claims.
China’s trade surplus—and hence its current-account surplus—is almost certainly bigger than that reported by Beijing, even if it is much smaller than the combined deficits reported by America and other trading partners. But for the rest of the global economy, the crucial thing is not the precise size of China’s surplus, but the fact that it is finally shrinking.
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