3. The European crisis will be accompanied by a trade shock.The second is here (from May 19th, for background). An excerpt
In the early 1980s Latin America countries were suddenly cut off from funding during what was subsequently called the LDC Debt Crisis, or the Lost Decade. These countries had been running large current account deficits, and of course current account deficits require capital account surpluses. These surpluses were financed by the the huge petrodollar recycling of the 1970s, when commercial banks around the world made staggeringly large loans to many developing countries.
Of course after 1981-82 it became clear that the loans exceeded the repayment capacity of the borrowing countries, and suddenly financing dried up – almost overnight. What’s worse, the debt crisis had already been preceded by flight capital, so that when financing dried up, a capital account surplus quickly became a capital account deficit. Of course once Latin America began to experience capital outflows, its trade deficit necessarily had to become a trade surplus. This is exactly what happened.
The deficit countries of Europe, whose combined trade deficits are nearly two-thirds the size of the US trade deficit, will also be forced into a rapid contraction in their trade deficits for the very same reasons – they are going to find it hard enough simply to refinance themselves, let alone receive net capital inflows. Without a capital account surplus, however, they simply cannot run current account deficits. This contraction must, one way or another, be absorbed by the very unwilling rest of the world.
Will southern European countries have trouble attracting capital inflows? Probably. In fact, almost certainly. In that case, they are all going to see sharp contractions in their current account deficits, exactly equal to the contraction in net capital inflows – and of course if any if these countries experience flight capital, this contraction can be very sharp. Again, the reasoning behind this is explained in an earlier post
To get a sense of magnitude, those four countries are the equivalent in trade deficit terms of more than half the US. If we assume that other European countries with large trade-deficits are also going to have to pay down debt, and may even find difficulty in attracting net capital inflows, then roughly 26% of all trade deficits in the world, an amount equal to more than two-thirds of the US trade deficit, are under pressure to contract rapidly.
Why does this matter to China? Because, of course, the global balance of trade must balance. Every dollar reduction in the trade balance of a European trade-deficit country must be matched, either by a dollar reduction in the trade surplus of Germany or some other European country, or by a dollar increase in Europe’s trade surplus.
Which will it be? Probably a combination of both, but the sharp decline in the value of the euro against the dollar makes it likely that we will see much more of the latter than of the former. In fact for many Europeans, the “silver lining” of the Greek crisis is that by pushing down the euro, it is making all of Europe, even countries like Germany that already have locked-in structural trade surpluses, more competitive in the international markets. Europe’s trade surplus is likely to surge.
So where is the countervailing trade impact? Beijing argues that the depreciation of the euro has automatically forced an appreciation of the RMB, and with deteriorating international markets, there is no need for China to accelerate the process. I would argue that with real interest rates declining in China, it is as if the RMB has been depreciating in real terms in order to protect China from the cost of the trade adjustment. China (along with Japan) does not want to bear the brunt of the global adjustment.
So that leaves the US. Most policymakers around the world – while publicly excoriating the US for its spendthrift habits – are intentionally or unintentionally putting into place polices that require even greater US trade deficits.
This cannot be expected to happen without a great deal of anger and resistance in the US. The idea that suffering countries should regain growth by exporting more to the world, and that rapidly growing surplus countries should not absorb much of this burden, will only force the US into even greater deficits as US unemployment rises to reduce unemployment pressure in Europe, China, Japan and elsewhere.