Global Imbalance

🤔 What’s the most obviously wrong thing in the world today?  

Well, besides the war in Ukraine, there are several candidates. There’s the global debt problem, which now comes to something like $300T—a “mere” 350% of Global GDP by the way and $37,500 for every person on the planet. Yikes! Then there’s the whole climate change thing and the fact that we don’t really have a global consensus or plan on how to deal with it. And we cannot forget about the massive global poverty problem, which now is trending in the wrong direction again. 

Clearly, as the pop-psychologists would say, we have some issues!

Let’s put these mega-issues aside for a second and talk about something which usually doesn’t make the list but is equally problematic. One of the most obviously wrong things in the world today is the Chinese currency peg. 

To understand the story here, let’s go back to August of 2019 and those golden days before the pandemic. Trump was President then and running his off-kilter communications strategy largely via Twitter. One day he ranted about China and labelled them a “currency manipulator.” As usual, his delivery was, let’s say, less than ideal, but here, unlike in most instances, at least he had a point. China has engaged in a decades-long program of foreign exchange rate manipulation, keeping the Yuan in a very strict range in terms of US dollars, and in the process created one of the greatest global economic imbalances in recorded history.

To understand why this is a problem we have to remember our elegant framework from Charles Gave. According to his theory, foreign exchange-rate manipulation is one the main causes for problems in the global economy. When a country the size of China messes around with their currency, it interferes, in a consequential way, with a critical link between the production and the financial operating system of the world. In effect, interference on this scale produces a bunch of distorted signals and market participants, consumers, and governments respond accordingly. If it goes on for long enough, you get a huge imbalance.

So, what has China been doing and why? This is all about their strategy to produce economic growth. As they were opening up in the 1990’s, they knew they had a once-in-history opportunity to become the low-cost provider for global manufacturing. Once they got into the WTO in 2001, it was game-on. Western multi-national corporations sensed the opportunity as well and were all-too-willing to outsource production (i.e. labor arbitrage) in the search of ever greater profits. I haven’t seen any research on this but it cannot be a coincidence that the period in which all these companies outsourced to China lines up perfectly with the period where CEO pay in the West went parabolic.

Anyway, the idea is simple: export as much as possible and use the money from foreign consumers to make massive long-term infrastructure investments at home. Geopolitically, this is a phenomenal strategy. Who wouldn’t want foreign consumers to pay for roads, bridges, airports, and even whole new cities? A cheap currency is absolutely crucial to this.

The numbers are staggering here. China amassed history’s largest cumulative trade surplus in just a few decades and, along with it, an absolutely massive stockpile of foreign currency reserves.

Title= China Trade Surplus in $’s and as % of GDP

China’s whole strategy has been dependent on key factor: making sure their exports remain relatively cheap in the global market. In other words, they simple have to prevent their currency from appreciating, most importantly against the US dollar.

The challenge here is that this is rather difficult to this when you also have staggering GDP growth. What happens normally (if that’s such a thing) is that the thriving GDP growth story will attract inbound capital flows from opportunistic investors. These flows, in turn, put natural upward pressure on the currency. So, there’s a balancing force there. In a world of free capital flows, you cannot just be the low-cost option forever. Unless, of course, you deliberately attempt to manipulate your currency like China. Over the last few decades China has spent at least $1T defending its currency and probably much more. It’s done so by keeping a relatively closed Capital Account (i.e. make it difficult for foreign investors to put large sums of money safely to work in China) while at the same time, intervening in currency markets whenever the Yuan moves too far in the wrong direction.

The macroeconomic problem with China’s strategy is that its neither benign nor sustainable. Yeah, it’s been great for China for sure. They’ve been able use this inflow of money to make generational investments at home, produce the largest economic growth cycle in history, and lift a historic number of people out of poverty. But what about everyone else? Here in the US, while we all have benefited from low-cost Chinese exports (e.g. look at the price of TVs), we’ve lost something like 2.5M manufacturing jobs and have run-up massive debts to fund an incredibly large trade deficit.

These global imbalances are not only economically unsustainable but also politically so. The Trump administration fired the first shots, in what will probably be a long geopolitical battle, by introducing tariffs. Although very early on in his administration Biden was quick to disavow the “currency manipulator” label, interestingly, he has kept the tariffs largely in place. The Biden administration also added some new policies to the mix with the Chips Act and the Inflation Reduction Act, both of which are attempts to incentivize the redevelopment of domestic manufacturing capability. 

While our leaders are finally waking-up to the reality of the problem here, it’s so late in the game that transitions away from these imbalances are likely to be economically painful for all sides. At this point, it’s hard to tell how this will evolve from here. Astute global macro hedge fund managers have been betting against the Chinese peg since all the way back in 2015 but nothing has changed and they’ve lost a lot of money along the way. I have to believe that at some point this dynamic breaks down but it’s impossible to say when. It’s something to keep a close eye on, that’s for sure.

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