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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Evidently focused on the potential impact of the burgeoning trade dispute with the United States, and aware of the fact that economic growth has lately decelerated, China’s authorities have taken a number of steps to boost economic growth. The People’s Bank of China, the country’s central bank, has injected US$74 billion into the economy by directly lending to commercial banks.1 This follows a move in June to reduce the required reserves held by commercial banks as well as a recent reduction in certain interest rates. The effect of these actions is to help put downward pressure on the currency. In addition, the Chinese government is taking fiscal action to stimulate the economy.2 This includes targeted tax cuts meant to boost research spending by businesses as well as the issuance of new bonds for infrastructure investment. The government said that these measures were meant to respond to “external uncertainties.”3 These actions together do not yet represent a radical shift in policy. Rather, they indicate that the government intends to tweak policy in a way that averts problems stemming from potential restrictions on trade.
The easing of monetary policy by China’s central bank has led to a relatively sharp decline in the value of the renminbi. It is now at its lowest level in about a year and it fell about 5 percent against the US dollar since the start of June.4 This has not been unnoticed by the US administration. A lower valued currency, by cutting export prices, could have the effect of offsetting the impact of US tariffs on Chinese exports. China, however, says that it is simply allowing the market to determine the value of the renminbi. China stopped pegging the renminbi over a decade ago, which led to a sharp rise in the renminbi. When the renminbi started to fall in 2015, the central bank sold a massive quantity of reserves to help prevent the renminbi from falling further. It has been argued that the renminbi is actually overvalued and that a decline in value is warranted. Thus, the recent decline might not necessarily be seen as out of the ordinary. In addition, the fact that the US Federal Reserve is in the process of raising interest rates suggests that the renminbi is likely to fall further. Yet aside from the economics of the currency, the political ramifications are likely important. If the US government is upset about China’s currency, this could influence US decisions about tariffs. It is worth noting that the movement of the renminbi so far is fairly small compared to the experiences of most other countries in similar circumstances.
In the United States, the Trump administration celebrated the fact that real (inflation-adjusted) gross domestic product (GDP) grew at an annualized rate of 4.1 percent in the second quarter, the fastest growth since the third quarter of 2014 when the economy grew at a rate of 4.9 percent.5 Compared to a year earlier, real GDP was up 2.8 percent, the fastest rate since the 3.4 percent growth clocked in the second quarter of 2015. The acceleration in growth had been widely expected, but might not be sustainable. One reason is that growth was partly fueled by a surge in exports that was due to substantial front-loading of foreign purchases of US agricultural goods. This likely happened because buyers were trying to avoid higher prices stemming from retaliatory tariffs imposed by China this month. The surge in exports, which accounted for 1.1 percentage points out of the 4.1 percent growth, will not likely be repeated in the next quarter. Thus, in the absence of the export surge, growth would have been 3.0 percent—still good, but not spectacular. Here are more details of the second quarter growth:6
Going forward, an important question is whether the current and prospective trade disputes will have any adverse effect on growth. Farm industry organizations are reporting that orders for exports have plummeted, boding poorly for export growth in the next quarter. Industrial companies are also reporting that their costs are rising due to tariffs.8 If they raise prices in response, it could hurt both external and internal demand for their products. If they hold the line on prices, their bottom lines will be hurt, likely causing them to cut back on investment. Meanwhile US equity prices fell on expectations that there will likely be a continued tightening of monetary policy.
Rebecca Porter, an economist at Deloitte UK, offers a primer on the latest actions and challenges concerning Brexit:
With less than nine months to go until the United Kingdom leaves the European Union (EU), the British government published a white paper setting out its vision for the country’s future relationship with the EU.9 The document set out plans to keep the United Kingdom in a facilitated customs arrangement for goods, thereby helping ensure frictionless trade with the EU and avoiding a so-called “hard” border in Ireland. The plan aimed to do this at the same time as restricting free movement of people and creating “regulatory flexibility” for the provision of services.
The proposals met immediate opposition among several UK members of Parliament, many of whom deemed it to be the “softest” form of Brexit. Those who want more autonomy from the EU were unhappy that the United Kingdom will effectively become a “rule-taker” and would have to adhere to the EU’s regulatory and customs arrangements for goods. The proposals do allow the United Kingdom to diverge from the common rule book for goods, although there would be consequences of doing so.
Political turmoil ensued with a number of resignations in opposition to the plan. Two senior Cabinet ministers, David Davis, the United Kingdom’s former Brexit Secretary, and Boris Johnson, the former Foreign Secretary, resigned in quick succession. In his resignation letter, Johnson claimed that the Brexit "dream is dying, suffocated by needless self-doubt" and the plan amounted merely to a “semi-Brexit.”10
The main sticking point in negotiations continues to be the Irish border “backstop,” a provision intended to help ensure an invisible Irish border in the event that a more preferable solution cannot be found during talks. The EU’s proposed backstop, which the United Kingdom agreed in concept in December 2017, but has since rejected, would effectively keep Northern Ireland in the EU’s customs union and single market until another solution is found, with no time limit.
With both the EU and UK governments in summer recess until the beginning of September, there is very little time left to finalize a withdrawal agreement. The EU summit in October is the most likely last practical opportunity to forge an agreement that can be ratified by the UK and EU Parliaments in time for the United Kingdom to leave the EU on March 29 next year. Crucially, an agreement should be reached on keeping Ireland aligned to the EU’s single-market requirements to secure a transition deal. In the absence of such a deal, the United Kingdom might undergo the “hardest of” Brexits by crashing out of the EU, with the immediate imposition of tariffs on goods and border checks from March 2019.
The Labour Party has opened up a slight lead over the Conservatives in opinion polls since the release of the white paper.11 Analysts suggest this reflects weaker support for the Tories among ”Leave” voters and could lead to more vocal opposition from Tory members of Parliament in “Leave-voting” marginal constituencies to this plan. As the timings get tighter, the likelihood of no withdrawal agreement being reached has risen. Betting markets currently imply a 64% probability (accurate on July 26, 2018)12 for a “no deal” Brexit and both the United Kingdom and EU have stepped up preparations for this scenario.
European Commission President Jean Claude Juncker went to Washington to meet President Trump, hoping to avert a trade war with the United States. He was successful, but only temporarily. Juncker and President Trump agreed that further tariffs will be put on hold while the two sides attempt to find common ground on key issues.13 This means that the threatened tariffs on automotive trade are no longer imminent, but not completely off the table. The deal means that the two sides will now engage in discussions about how to reduce trade barriers on a wide range of non-automotive industrial products. The two sides will also discuss unspecified reforms of the World Trade Organization (WTO). Trump suggested that the deal is a big victory for the United States. He said, “We just opened up Europe for you, farmers. You’re not going to be too angry with Trump.” Yet the deal with the EU does not deal with agricultural trade. Still, Trump has faced a backlash from farmers over his trade policy, so he was likely keen on offering them an olive branch. He also said that the EU pledged to buy soybeans and natural gas. The EU currently buys neither of these products from the United States. In the case of natural gas, the major impediment to EU purchases is US export restrictions. Rather, the one-page statement issued by the two sides merely pledges to negotiate over trade in non-auto industrial products and the rules of the WTO. The EU is likely pleased with the deal in that it temporarily averts tariffs on automobiles, which could have been very costly for automotive companies as well as for consumers on both sides of the Atlantic. An analysis by a leading think tank estimated that tariffs would add between US$1,400 and US$6,900 to the retail price of automobiles sold in the United States.14 Still, the EU failed to get the United States to back down on existing tariffs on steel and aluminum. It is too early to say whether this agreement is significant or likely to hold. When, in May, the United States reached an agreement with China to avoid tariffs, Trump changed his mind within a few days and tariffs have since been implemented.
Reaction in Europe to the EU-US trade deal was mixed.15 German political leaders were mostly exuberant, largely reflecting the fact that German automakers are hugely dependent on the US market. For now, they have avoided the potential loss of many jobs in the automotive sector. However, France’s government expressed some hesitation, concerned that any removal of barriers on industrial trade will not deal with non-tariff issues such as government procurement or safety standards. In addition, many political leaders expressed concern that the deal is merely temporary, and neither rolls back existing tariffs nor eliminates the likelihood of new tariffs. As such, it hardly provides businesses with the kind of stable roadmap they likely need in order to make big investment decisions.
Having what many would classify as a tumultuous summit with US allies, and a friendly meeting with Russian President Putin, President Trump has likely caused a significant shift in the US foreign policy. Upon arriving in Helsinki to meet Putin, for example, he said in an interview that the European Union is America’s “biggest foe globally right now.”16 And he appears to be rapidly engineering a potential dramatic shift in the dominant viewpoint of the Republican Party. In fact, his foreign and economic policies are somewhat reminiscent of an earlier Republican focus. One could say that, since the 1930s, there have been four major Republican philosophies regarding US interaction with the world, with Trump’s viewpoint being the fourth one and being similar to the first. Let me explain:
A few questions now emerge:
The Chinese economy grew 6.7 percent in the second quarter versus a year earlier.20 This was the slowest rate of annual growth since the third quarter of 2016. However, real GDP was up 1.8 percent from the second to the third quarter.21 This was the strongest quarterly growth since the third quarter of 2017. The annual slowdown reflects the impact of the government’s efforts to cool credit markets, the effect of which was to suppress growth of fixed asset investment. In fact, fixed asset investment in the first six months of the year was up only 6.0 percent from a year earlier,22 the slowest expansion on record. In addition, efforts to slow the expansion of local government borrowing resulted in a slowdown in the pace of infrastructure investment, which was up only 3.0 percent in the first half of the year versus a year earlier. Meanwhile, private sector investment grew a healthy 8.4 percent, which included a 6.8 percent increase in investment in manufacturing. Still, the economy continued to grow faster than the government’s target of 6.5 percent. There is concern about the potential impact of the growing trade dispute between the United States and China. Credit policy has been eased in order to offset the effects of weakening trade flows.
Inflation in the Eurozone accelerated in June, with consumer prices up 2.0 percent from a year earlier, the fastest rate of inflation in 16 months.23 The principal reason was the sizable increase in energy prices in the past year. Energy prices in the Eurozone were up 8.0 percent from a year earlier. However, when volatile food and energy prices are excluded, core prices were up only 0.9 percent in June versus a year earlier.24 This was in line with the experience of the last two years and suggests that underlying inflation is not accelerating. Thus, from the perspective of the European Central Bank (ECB), there is likely no reason to tighten monetary policy. The ECB has indicated that it will soon end its policy of quantitative easing (asset purchases), but will continue to maintain historically low interest rates. It is not actually surprising that core inflation remains low. After all, in many countries in the Eurozone there continues to be very high unemployment. With considerable slack in these labor markets, there is no reason for wages to accelerate, something that would fuel higher inflation. By country, inflation in June was lowest in Ireland (0.7 percent) and Greece (1.0 percent), and was highest in Belgium (2.6 percent) and Luxembourg (2.4 percent).25
One of the potential signs that a recession might be imminent would be an inversion of the yield curve, in which short-term interest rates exceed longer-term rates. This hasn’t happened yet in the United States, but the yield spread has been narrowing. The gap between the yields on two-year and 10-year government bonds is now the lowest it has been since 2007, just prior to the last recession. An inversion could be worrisome because it could reduce the incentive for banks to create credit. Thus, some Federal Reserve officials are concerned that further tightening of monetary policy could be counterproductive if it leads to an inversion. Atlanta Federal Reserve President Raphael Bostic said that “any inversion of any sort is a surefire sign of a recession. I want us to avoid being in a situation where”26 the yield curve inverts. Bostic said that the Fed should not explicitly target the yield curve in its deliberations, but that it ought to be careful to avoid an inversion. Other Fed officials are said to be in agreement. An inversion could take place if, by tightening monetary policy further, the Fed causes long-term yields to be suppressed owing to reduced expectations of inflation. This could come about, however, by raising short-term rates. Hence, an inversion. For the Fed, the challenge is to tighten sufficiently to anchor inflation expectations while, at the same time, not killing the goose that laid the golden egg.
Meanwhile, the US Federal Reserve says that the strengthening US economy, and its abundance of jobs, is causing a large number of previously sidelined workers to return to the labor force. In a report, it notes that the share of working-age adults participating in the labor force has steadily increased since 2013.27 Moreover, it believes that there is room for further increases in participation, thus allowing employment to continue growing faster than the working-age population. This can bode well for reasonably strong economic growth without necessarily igniting inflation. That is because, with the expansion of the labor force, the increased supply of workers could prevent a shortage of labor that would otherwise cause an acceleration in wages. At the same time, if the sidelined workers that want to return to the labor force lack the skills being demanded, then there could be shortages of labor. There are already shortages in some professions.
Despite the weakness of wages, Fed Chairman Jay Powell said in an interview that the strength of the economy is sufficient to warrant a continued tightening of monetary policy. He said that inflation expectations are where the Fed intends and, consequently, the Fed can raise interest rates without harming the economy. Indeed inflation in the United States continues to accelerate, in part due to the sharp rise in energy prices over the past year. In June, consumer prices were up 2.9 percent from a year earlier, the fastest rate of inflation since February 2012.28 Gasoline prices were up 24.3 percent from a year earlier. However, when volatile food and energy prices are excluded, core prices were up 2.3 percent from a year earlier. This was the fastest rate of core inflation since January 2017. Moreover, underlying inflation has now exceeded the Federal Reserve’s target of 2.0 percent for four consecutive months. Thus, even excluding the impact of energy prices, it is clear that underlying inflation is accelerating, likely reflecting tightness in the labor market and the bottlenecks that stem from an economy in overdrive. Meanwhile, Fed Chairman Powell said, “I sleep pretty well on the economy right now.”29 However, given the many risks that the economy now faces, it is increasingly likely that his sleep will be interrupted.
Earlier this month, the United States imposed the first round of tariffs on US$34 billion in imports from China. The Chinese government promptly retaliated with tariffs on a similar volume of imports from the United States. Now, the United States intends to retaliate much further. It has begun the review process in anticipation of imposing a 10 percent tariff on US$200 billion in imports from China. This will entail a wide range of products. The Chinese government says that, if the United States does this, it will retaliate commensurately. However, the United States exports less than US$200 billion in goods to China. Thus, any Chinese retaliation will likely involve non-tariff measures. So far, Chinese retaliation has been carefully targeted toward industries that are located in states that are politically important to President Trump. Meanwhile, the president said that, if China retaliates to the newest US initiative, the United States might impose tariffs on another US$200 billion in imports. The US side says that its actions are meant to compel China to change its policies regarding the protection of intellectual property. US trade negotiator Robert Lighthizer said, “We have been very clear and detailed regarding the specific changes China should undertake. Unfortunately, China has not changed its behavior—behavior that puts the future of the US economy at risk.”30 For its part, China’s Commerce Ministry said that it is shocked and that it “has no choice but to take necessary countermeasures.”31 Supporters of China’s position note that its external surplus has fallen in recent years and that its payments of royalties and license fees for intellectual property have increased sharply.
Many American companies produce goods in China for export. In fact, of the top 100 exporters in China, 70 are non-Chinese companies. 32 Thus, many US companies are concerned that tariffs imposed by the US government will hurt their ability to source goods in China. In addition, a spokesman for the National Retail Federation, a US retail industry trade association, said that “tariffs on such a broad scope of products make it inconceivable that American consumers will dodge this tax increase as prices of everyday products will be forced to rise. The retaliation that will follow will destroy thousands of US jobs and hurt farmers, local businesses and entire communities.” Many leaders of the US technology industry, which is meant to be the beneficiary of the administration’s efforts, have urged the administration not to impose tariffs. The industry relies heavily on trade in both directions and worries about higher costs and supply chain disruption. The US administration’s plans also attracted the concern of many leading Republican members of Congress. Members from farm states and states dependent on the automotive industry are especially concerned.
Investors reacted sharply to the US proposal. Global equity prices, bond yields, and commodity prices all fell on the news. The value of the US dollar increased and the value of the Chinese renminbi fell. Investors were evidently concerned that a further trade war could have potential negative consequences for the global economy. A new round of tariffs and other trade barriers will likely result in higher prices, lower real purchasing power for consumers, disruption of supply chains, and initially a decline in business investment. Also, the higher prices that tariffs will entail might temporarily boost inflation, thus making the Federal Reserve’s job a bit harder. For now, it is not clear what the end game will be for the United States. It wants China to change policies regarding technology acquisition, and it wants to reduce the US trade deficit with China. So far, there is nothing to indicate that China will make any changes in response to the US action. Moreover, there is likely not much that China can do to reduce the trade imbalance. Thus, there appears to be a strong likelihood that the trade war will continue and possibly intensify.
In the last six months, industrial production in the Eurozone has decelerated, but has continued to grow. In May, industrial production was up 2.4 percent from a year earlier, having grown as fast as 5.1 percent in December.33 There has been a sharp slowdown in production of consumer durable goods as well as energy. Output of capital goods, while decelerating, continues to grow at a pace of 3.9 percent, which bodes well for continued growth of business investment. By country, industrial production is up 3.0 percent in Germany, down 0.6 percent in France, up 2.1 percent in Italy, and up 1.9 percent in Spain versus a year earlier. In contrast, Eurozone industrial production increased 1.3 percent from April to May, the biggest one-month gain since November 2017. Still, the annualized slowdown reflects several likely factors. These include the potential negative impact on demand from rising energy prices, the evident slowdown in global growth, the lagged impact of a rise in the euro, and the uncertainty about trading relations with the United States. Indeed the European Commission stated that “if trade tensions with the US were to escalate further, this could dampen confidence more permanently, weighing on global investment and trade flows, and likely disrupting the current global cyclical upswing.”34 The commission downgraded its growth forecasts due to trade tensions and higher energy prices. It especially downgraded its forecast for growth in Germany,35 expecting Germany to be adversely affected by trade restrictions imposed by the United States. It also expressed concern that trade tensions between the United States and China could have a negative spillover effect on Europe. In contrast, the European Central Bank (ECB), in a recent statement, indicated confidence in the continued growth of the Eurozone economy, despite adverse effects of trade. It said that “while the incoming data had been somewhat weaker than previously expected, the fundamentals remained in place for the medium-term growth outlook to remain solid and broad-based.”36 The bank also expressed “increased confidence that price and wage pressures would strengthen further over time.” Thus, the ECB intends to follow through on its plans to end quantitative easing (asset purchases) later this year.
Meanwhile, house prices in Europe are rising rapidly.37 In the first quarter of 2018, house prices in the 19-member Eurozone were up 4.5 percent from a year earlier, the fastest rate of increase since 2007. House prices in the larger 28-member European Union were up 4.7 percent. The biggest increases took place in Iceland and Latvia (both up 13.7 percent), Slovenia (up 13.4 percent), Ireland (up 12.3 percent), Portugal (up 12.2 percent), Slovakia (up 11.7 percent), and Hungary (up 11.5 percent). Prices fell in Italy, Finland, and Sweden, and rose very modestly in France and Belgium. Prices were up strongly in Spain. A sharp rise in asset prices is often a signal that there is too much liquidity in an economy and/or that borrowing costs are too low. Thus, the housing price data could reinforce the view that the ECB is correct in its determination to soon end asset purchases. Although the ECB has no plans to raise interest rates any time soon, several governments in Europe are tightening mortgage-lending standards in order to avoid housing price bubbles. When bubbles burst, they hurt borrowers and lenders alike. Ireland and France are both increasing banks’ required capital buffers.
The Chinese renminbi has been falling rapidly recently. In response, the head of China’s central bank, Yi Gang, said that the bank would keep the currency “basically stable at a reasonable and balanced level.”38 This appeared to calm investors’ nerves and caused the currency to rebound sharply immediately following his statement. The downward movement of the renminbi has likely been due to a confluence of factors including the upward movement of the US dollar, a narrowing of the spread between US and Chinese interest rates as the United States tightens monetary policy and and China loosens policy, and investor fears about the potential impact of a trade war between the United States and China. An important question now is whether a further depreciation of the renminbi is warranted. There are generally two schools of thought about this.
On the one hand, supporters of currency depreciation may say that the currency is overvalued and that, consequently, explains the weakness of export growth in recent years. Indeed, the real (inflation-adjusted) effective exchange rate for the renminbi has risen in value by about 25 percent in the past six years.39 This means that either export prices have risen and/or profit margins have fallen. In addition, depreciation may be warranted in order to offset the negative consequences of trade restrictions that are now being imposed. Finally, given China’s still-low rate of inflation, there is likely little danger that depreciation will cause serious inflationary consequences.
On the other hand, further depreciation of the currency could exacerbate the already serious trade tensions between the United States and China. In addition, depreciation could mean that Chinese debtors with dollar-denominated external debts would face greater difficulty in servicing those debts. Also, the expectation of further depreciation could lead to an increase in capital outflows, thus causing a faster depreciation than would otherwise be the case. In such a situation, the central bank might be compelled to sell foreign currency reserves in order to slow the drop in the currency.
The European Union (EU) wants to avert a debilitating trade war over automobiles. Consequently, it is considering proposing that tariffs on automotive trade be eliminated by multiple countries.40 First, a little background on automotive trade.41 The US currently imposes a 2.5 percent tariff on imported automobiles, while the EU imposes a tariff of 10 percent. The difference has been a thorn in the side of the United States. However, the United States also imposes a tariff of 25 percent on imported sport utility vehicles (SUVs), which include light trucks and minivans. There are no tariffs on automotive trade between the United States, Canada, and Mexico, because of The North American Free Trade Agreement (NAFTA). China has a 25 percent tariff on imported vehicles and stated in May that it would cut that to 15 percent. However, with the United States imposing new tariffs on China this week, China said that it will boost the tariff on cars in response. Japan has no tariff on auto imports and Korea is eliminating its tariff as part of a previous free trade agreement with the United States. However, many countries, including Japan, engage in non-tariff barriers, such as regulatory restrictions. The TransPacific Partnership, from which the United States withdrew, was meant to address such issues by restricting the ability of countries to impose non-tariff barriers. The Trans-Atlantic Trade and Investment Partnership (TTIP), the proposed free trade deal between the United States and the EU, was also meant to address non-tariff barriers. However, negotiations on the TTIP stopped once the new US administration took office.
Now, the United States is investigating whether automotive imports threaten national security, as a prelude to imposing a 25 percent tariff on all imported automobiles.42 This idea has caused considerable concern on the part of automotive companies on both sides of the Atlantic. They note that the automotive industry involves highly integrated global supply chains. A car assembled in one country contains parts made elsewhere. Moreover, many US automakers are worried that tariffs on imported components will significantly increase the cost of assembling cars in the United States, thus forcing much higher prices for consumers. Indeed many major automakers said that the tariffs could lead the average price of a car sold in the United States to rise by US$6,000.43 The head of a major US automotive trade group said that “the imposition of a 25 percent tariff on autos and auto parts, on top of the Section 232 steel and aluminum import tariffs and the Section 301 tariffs on Chinese imports, would result in a total new tax burden of more than $90 billion annually on the U.S. automotive industry.”44 The EU is now looking for a way to assuage US concerns and avoid dire consequences. The EU is considering a proposal that would entail having countries accounting for more than 90 percent of global automotive trade eliminate tariffs, thus meeting requirements of the World Trade Organization.45 These would likely be the EU, United States, Japan, Canada, South Korea, Mexico, and possibly China. It is not clear if the plan would include automotive parts, or if it would address non-tariff barriers. There has been no comment yet from the United States.
If a broad deal on automotive trade cannot be reached, the EU has told the US government that it will contemplate new tariffs on roughly US$300 billion of goods imported from the United States.46 That would represent roughly 20 percent of all US exports. While the EU provided no details, it indicated that tariffs could be imposed across the board. In its statement to the United States, the EU stated that the tariffs the United States is threatening to impose represent “yet another disregard of international law.”47 It noted that about one quarter of all cars assembled in the United States are made by European companies, with most of them being exported. Thus, the EU appeared to hint that these investments, and the jobs they entail, would be at risk in the event of a trade war. In the absence of a deal, and if tariffs are imposed, the world’s leading automotive companies are likely to make significant changes to their global supply chains, especially changing the location of final assembly in order to avoid tariffs. Imposing tariffs will likely increase costs for consumers, lessen consumer choice, lower consumer demand, reduce car and light truck production and sales, lower investment levels, and lead to job losses in the US automotive sector. It is not clear how this dispute will unfold, but there is clearly a risk of higher costs resulting in a supply-chain disruption and weaker growth of consumer spending in both the United States and Europe.
In Mexico, a landmark election took place recently, resulting in the first-ever leftist elected president in modern times. Morena Party leader Andre Manuel Lopez Obrador, best known by his initials AMLO, won a landslide victory,48 ushering in a new era in Mexican politics. His party will have control of the Congress, thus enabling him to legislate his agenda. AMLO ran on a platform that is a mixture of leftist and centrist ideas, but mostly populist in nature.
On the one hand, despite past opposition, he now favors continuation of NAFTA. He also agrees to the energy market reforms instituted by the current government. He says that he will balance the budget without raising taxes, and will not disturb the central bank’s independence. On the other hand, he remains protectionist in that he aspires to make Mexico self-sufficient in food and refineries. AMLO wants to significantly boost government spending to build infrastructure and to alleviate poverty. He expects that a reduction of official corruption will be sufficient to finance his spending plans. The question arises as to what kind of president AMLO will be. Some critics worry that he will go down the path of the late Hugo Chavez in Venezuela, and implement harsh socialist policies that could undermine the market economy and lead to economic ruin. Others, however, see him as being more akin to Luiz Inácio Lula da Silva, better known as Lula, who was the president of Brazil in the early part of this century. Lula came to power as a socialist labor leader, but governed as a marketoriented centrist. He mostly left the market economy alone, but shifted resources to the poor. Investors appear to be leaning toward believing that AMLO will be more like Lula. The peso rose following the election on expectations that a new period of stability is likely imminent.
Regarding relations with the United States, the end of the election cycle will likely bring a renewal of NAFTA talks.49 AMLO will not take office until December 1, so it is possible that key decisions will be delayed until then. Negotiations can take place with an understanding of the viewpoint of the incoming Mexican government. However, President Trump says that he wants to wait until after the US midterm elections in November to complete the NAFTA deal. Thus, the outlook for NAFTA remains uncertain. In any event, AMLO might be more amenable than his predecessor to the US demand for higher labor standards and wages. He might also be amenable to the kind of managed trade arrangements that the United States seeks, although it is not clear that Canada would agree to such ideas.
With 130 million people, Mexico is the 15th-largest economy in the world, just behind Spain and ahead of Indonesia.50 It is the second-largest economy in Latin America after Brazil. It is the third-largest trading partner of the United States after China and Canada. Mexico receives the fourth-largest volume of remittances from overseas after India, China, and the Philippines. What happens in Mexico should matter for the rest of the world.
In Japan, household spending fell sharply51 in May even as wages accelerated.52 Specifically, real (inflation-adjusted) wages in Japan were up 1.3 percent in May versus a year earlier, the fastest rate of increase in two years. There was a reduction in the share of workers who work part time, and there was a big increase in special payments such as bonuses. These factors contributed to the strong rise in average real wages. Yet households did not respond. The government reports that nominal household expenditures fell 3.9 percent from a year earlier, the sharpest decline in nearly two years. The decline was consistent across most major spending categories. This bodes poorly for overall consumer spending growth in the second quarter. The government has been keen to see wages accelerate in order to fuel increased consumer spending. It has been concerned that the economy is too dependent on exports for growth. The latest data suggests that higher wages are not yet sufficient to generate stronger consumer spending.
The Russian government’s plans to reform the pension system have resulted in major street protests across the country. The reforms are meant to deal with a serious demographic problem that is not unique to Russia. The working-age population is declining due to the lagged effect of a low birth rate. The cost of servicing pensions is, therefore, becoming onerous. To deal with the problem, the government intends to significantly raise the retirement age at which recipients receive benefits.53 What is unique to Russia is that older workers tend to receive lower wages than younger workers. That is because older workers, raised during the Soviet years, generally have less useful skills than younger workers. As such, many people close to retirement are living on extremely modest wages and look forward to pensions in order to supplement their wages as they continue to work in the informal economy. If pensions are delayed, these people will likely see a drop in their living standards. Hence, the protests. Indeed, a poll found that 80 percent of respondents object to the reforms.54
There is much talk about how the US trade deficit is causing harm to the US economy, with it being suggested that the deficit is due to trade restrictions on the part of other countries.55 However, the reality is that trade deficits reflect an imbalance between a country’s saving and investment. Yet this is not intuitively obvious. So, I thought that a very simple example might help to explain why this is so.
Assume that the United States and China are the only countries, and shoes are the only traded product. Assume that China sells shoes to the United States, but the United States sells nothing to China. Thus, the United States has a trade deficit with China. China is accumulating dollars that it cannot spend because it does not import anything from the United States. So, it purchases US corporate bonds and earns interest.
Suppose American households and businesses save very little, but American businesses invest a great deal. The difference is thus made up by the Chinese bond purchases. If the United States suddenly decides to invest less, the supply of bonds would decline, interest rates would drop, and the value of the dollar would fall as Chinese demand for bonds falls. This, in turn, will reduce US imports of shoes, which would have become more expensive in the United States. In other words, a change in the difference between investment and saving in the United States will influence the trade balance. In this case, a drop in the excess of investment over saving will reduce the trade deficit.
The important point is that the trade deficit is the counterpart of a net inflow of capital into the United States. If the United States boosts tariffs, the difference between investment and saving will not necessarily change. Instead, the US dollar will most likely appreciate and the trade deficit will likely remain unchanged. If the goal is to cut the trade deficit, then a country should either cut investment and/or boost savings. The best way to do that is to engineer a recession, which is not a desirable thing to do. Moreover, in this example, the trade deficit is neither good nor bad. Rather, it is simply the result of how the United States chooses to finance investment as well as how much to invest. Indeed, in our stark example, the United States makes out quite well, consuming Chinese shoes without having to work at producing anything in exchange. China, in contrast, works hard to produce shoes and merely accumulates US dollar-denominated assets in return.
So, is there ever a time when trade deficits are a bad thing? The answer is yes. When a country runs a trade deficit, it accumulates external debt, which must be serviced. If the debt becomes large, a country could be at a risk of having difficulty servicing it, especially if its currency depreciates, thereby increasing the domestic currency burden of servicing the debt. Moreover, if the inflow of capital is used to pay for consumer spending rather than investment, it contributes nothing to economic growth and, thus, to the ability to service future debt. This kind of situation is normally associated with poorly managed emerging markets.56 Such countries often take on debt denominated in US dollars, generate foreign currency by exporting commodities, and are at a risk of facing declining commodity prices, which often leads to currency depreciation.
In the case of the United States, however, all of its external debt is in US dollars, so it faces no currency risk. Moreover, although the United States is currently a net external debtor, the interest it pays on its debt is lower than the interest it earns from its overseas assets. As a result, it generates a net surplus on its external position. Thus, the United States is not at a risk of facing any difficulty in servicing its overseas obligations. Moreover, inflows of foreign funds have contributed to US investment in productive capital. Thus, in my opinion, the US trade deficit is not worrisome, nor is it likely having any negative impact on growth. The same can be said of most developed economies, although the United States is in the unique position of not facing any currency risk, given the primacy of the US dollar. This has been called the “exorbitant privilege” of the United States.57
China’s leaders are evidently concerned about the potential impact of the burgeoning trade war with the United States. If cross-Pacific trade decelerates, China could offset the negative economic impact by stimulating the domestic economy. As such, the People’s Bank of China (PBOC), the country’s central bank, has cut the required reserve ratio for commercial banks,58 thus boosting the amount of money available for lending by roughly US$100 billion. The new ratio will take effect on July 5, the day before the United States implements new tariffs.
The decision to boost credit availability comes at a time when the government is keen to avoid an excessive buildup of debt. Consequently, the government will require banks to carefully “target” the new funds.59 Large banks will be encouraged to facilitate debt for equity swaps for large, heavily indebted companies to help reduce onerous debt. However, the PBOC emphasized that banks will avoid helping “zombie” companies that are unlikely to survive without help. Smaller banks will be encouraged to lend to small-and medium-sized enterprises. The policy, by boosting credit but also helping companies to reduce debt, appears to be a compromise between stimulating the economy and restraining debt.
Meanwhile, China’s central bank has allowed the renminbi to fall sharply in recent days, dropping to its lowest level since December 2017.60 It is likely that market forces have suppressed the renminbi, especially given the rising value of the US dollar. Yet China could intervene to prevent such a depreciation, but has not done so. This could inflame tensions with the Unites States. After all, a declining renminbi could ultimately boost the price competitiveness of Chinese exports, thereby helping to offset the impact of US tariffs.
Turkish President Erdogan won reelection as the president, while his party’s coalition retained control of the parliament. Under the revised constitution that the voters had previously approved, the person elected president this year will have substantially increased powers, including the ability to rule by decree. Thus, there is widespread interest in the intentions of Erdogan. In the recent past, he has indicated an aversion to classic economic policy, suggesting that high inflation could be tackled by cutting interest rates.61 This worries investors who fear that the government could reduce the independence of the central bank and implement policies that could exacerbate the already-high inflation and cause further currency depreciation. Thus, it is no surprise that Turkish bond yields have risen on concerns regarding the future of economic policy.62 These concerns come at a time when emerging markets in general are under stress.
With the US Federal Reserve tightening monetary policy, and with bond yields on the rise in the United States and Europe, emerging markets have seen an increase in outbound capital flows, resulting in likely downward pressure on currencies. Turkey has been hit especially hard due to high inflation, a large external deficit, and concerns regarding the Turkish policy. The Turkish economy is widely seen as overheated.63 Thus, a tightening of the monetary policy is likely warranted even in the absence of external factors pushing down the currency. The question now is whether the Turkish government will be willing to allow the central bank to temporarily weaken growth to fight inflation.
Italian bond yields have remained elevated since the recent formation of a new government whose leaders have expressed an interest in boosting spending.64 Yet, interestingly, the yield on the 10-year Italian government bond is now roughly the same as that on the US bond. How could that be? After all, the US government could print money in the currency in which it issues bonds, a power that Italy lacks. This makes the risk of a default by the United States roughly zero, while the probability of a default by Italy is almost non-trivial. Moreover, Italy has a larger debt and higher debt servicing costs as a share of GDP than the United States, thus making its debt more onerous.65 In contrast, investors might be confident that, if something goes wrong for Italy, the European Central Bank will intervene and save the day.
Since the formation of the Italian government, bond yields have been quite volatile, even though they have remained elevated. The volatility may reflect investor uncertainty about the future direction of the government. It initially called for steep increases in spending. Yet the new finance minister has assured that Italy will abide by European Union (EU) fiscal rules. Thus, investors are not sure if Italy will be confrontational or cooperative with the EU. Meanwhile, bond yields for Spain remain about half those of Italy, and yields on Greek government bonds have fallen substantially on news that Greece’s economy is growing.
The tax law passed by the US Congress at the end of last year lowered the tax rate on profits held overseas by US companies, effectively eliminating the incentive to hold profits overseas. The result has been a rapid inflow of capital into the United States. In the first quarter of 2018, US companies repatriated an estimated US$305 billion in profits held overseas.66 In addition, share buybacks by US companies hit a record high level in the first quarter. It is likely that these two events were related. Moreover, it is reported that companies with the largest volume of profits held overseas (such as technology companies) engaged in unusually large share buybacks.