Chinese excess savings, declining world trade, and the rising US dollar

Brad Setser has an intriguing piece that tries to understand how Chinese money flows are influencing the current economic dynamic.

From what I gather, he is essentially saying that :

a. China’s exports may be slowing, but imports are slowing faster, leading to a wider Chinese trade surplus

China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus.

b. The slowing Chinese economy may be reducing investment growth, but savings growth is decreasing less, and it is creating more local “excess savings” that could now be re-lent elsewhere

China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world.

c. A slowing Chinese economy would lead people to believe that the government will devalue the yuan, and Chinese households anticipating this will want to hold dollars instead

A big fall in output might lead China’s savers to lose confidence in China, or rather to lose confidence in the RMB bank accounts as a stable store of value. The big fall in output might, for example, create expectations that China would devalue the RMB v the dollar — and Chinese households, anticipating the devaluation, would have a strong incentive to hold dollars.

d. In previous years when Chinese government wanted to keep yuan down and keep inflation down, it sterilized money by increasing its Central bank’s assets. Now that the goal is to get (Chinese) banks lending again in a contracting economy, the Chinese central bank will reverse this policy

China potentially faces the opposite problem. Money is flowing out, reserves are no longer growing, deflation is a bigger threat than inflation and banks may no longer want to lend. I wouldn’t worry too much though about the risk that the money supply will shrink just because China’s reserves aren’t growing. Growing reserves can lead to money creation. But so can the same stock of reserves and less sterilization. And the PBoC has enormous scope to reduce the scope of its sterilization operations. The recent cut in the reserve requirement is an obvious example.

e. This leads to more currency flowing around in China that Chinese people may opt to hold in US dollars

Someone in China will still buying foreign assets — and likely providing indirect support for the Treasury market — even if it is not China’s central bank.

So the worse off the world economy gets, more money will be flowing to the US dollar. The stronger the US dollar, and the weaker the yuan. The more expensive American exports get, the cheaper Chinese exports become.

The excess Chinese savings will lead to a bubble, no longer in American private lending, but in US Treasuries. The excess saving will no longer come from the Chinese Central bank, but from Chinese private savers.

What does this bode going forward? The US government will get cheap money on the scale enjoyed in the last few years by US financial institutions. It can afford to splurge more money on projects with ever-lower returns. Or, it can turn the problem back on China, by using the money to subsidize American goods, so they sell in America for lower than the Chinese imports.

Wouldn’t that be ironic, to see Chinese citizens subsidizing American consumers, to buy US-made goods.