China And The Trade Imblances Issue Caused By The Euro Crisis

Posted the other day How Euro Crisis Is Hurting China

I have been waiting for Professor Pettis to write on this issue and he has not failed me.

It's an extremely interesting view point. Long as usual.

Don’t misread the trade implications of the euro crisis for China

• .... To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:
  
  1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing. At best they will be able, through official help, to refinance part of their existing liabilities.
  
  2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
  
  3. If European trade deficits contact, there must be one or both of two automatic consequences. Either the trade surpluses of Germany and other European surplus countries – larger than that of China and just a little larger in sum than the European deficits – must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
  
  4. We will probably get a combination of the two, but a much weaker euro – combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption – will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
  
  5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
  
  6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
  
  7. The only way for this not to happen is for the deficit countries to intervene in trade themselves. Since the US cannot use interest rates, wage policies or currency intervention to interfere in trade, it must use tariffs.
  
  
  Tariffs in the US, Asia and probably in Latin America and Europe will rise. These are big numbers and the risk is that the adjustments are likely to occur rapidly. This means the rest of the world will also have to adjust just as rapidly.
  
  I don’t really see how the numbers are going to work. Europe, China and Japan are all implicitly demanding that the US trade deficit rise to help them through their domestic employment problems. The US has its own domestic employment problems and is determined to bring the trade deficit down. Both sides cannot win and there doesn’t seem to be much serious attempt at global coordination. In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.
  
  So the hard part of the global coordination is almost certain to fail. It will take a few months for the impact of the euro weakness and the withdrawal of net financing to deficit Europe to be felt, but it will be felt. Expect trade tensions to get nastier than ever by the end of this year or the beginning of the next.
  
  By the way is there anything that China can do to head off conflict? Yes. It can buy euros, the more the better –just lift every offer out there. By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China. Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.
  
  But make no mistake – if southern European trade deficits decline, someone somewhere must bear the brunt of the corresponding adjustment. The only question is who?