The real bully in the America-China trade war

My interest in this story – always high – was heightened by the series of tweets issued by Prof. Richard Baldwin against Michael Pettis for saying that trade surplus countries have more to lose from trade wars than trade deficit countries. Frankly, as a matter of principle, it is no different from the statement that expanded trade is win-win for all trading partners. But, as always, the devil is in the details. I thought Richard Baldwin protested too much, making it sound almost personal.

For Prof. Baldwin, these were the offensive remarks:

“For political reasons, China has to respond,” said Michael Pettis, professor of finance at Peking University. “But China risks an escalation. There’s an asymmetry here: trade war is extremely dangerous for surplus countries.” [Link]

Of course, a cursory glance at his tweets suggests that he is like many commentators – viewing things through the prism of Donald Trump rather than through the prism of efficacy or desirability or, preferably, both.  In his tweets, Richard Baldwin drew attention to a NBER paper of his from 2013 on global supply chains and I have dutifully downloaded it. Not read it yet.

But, just as I had not read Baldwin’s paper and hence, reacting to his tweets, it is equally possible that Baldwin had not read Pettis’ previous works and been reacting to a one-line quote in a newspaper article.

In a long paper he wrote for Carnegie Endowment in 2017, Michael Pettis wrote thus:

Some economists argue that even if there are short-term benefits to American producers and workers, over the longer-term trade intervention is harmful for U.S. productivity growth. This argument, which seems more ideological than empirical, is based on standard trade theory in which there is an implicit assumption that any intervention will drive trade performance away from its optimum, so that the United States always gains from the further opening up of its own market, even if trade partners don’t reciprocate. There are at least two problems with this argument.

First, it doesn’t seem to conform to historical precedents, most especially American historical precedents, that suggest trade intervention has indeed been a successful part of many countries’ growth strategies. In fact, with the exception of a few, small trading entrepôts whose needs are radically different from those of larger economies, it is hard to think of a single advanced economy whose period of most rapid growth has not benefitted from, or at least coincided with, trade and industrial policies.

Second, the idea that any U.S. intervention necessarily pushes the U.S. economy from an optimum in which productivity is maximized simply does not make sense. It is easy to design models that show how mercantilist policies in one country, whether intended to be mercantilist or not, can push another country away from its previous equilibrium, so that if the second equilibrium is closer than the first to the optimum, trade policies can clearly improve productivity. And if the second equilibrium is not closer, trade policies just as clearly can improve productivity if they force a return to the first equilibrium. This is just logic.

The claim that trade intervention is always value-destroying or always value-enhancing cannot be other than ideological. We must develop a framework in trade theory that recognizes the conditions under which specific interventionist policies can enhance or undermine long-term growth prospects, after which we must apply that framework to current circumstances. – Link; emphasis mine

The senence above bold-faced, is a reasonable one. Ultimately, answers to predictions derived from eonomic theories have to be empirical/evidence-based.

Before we turn to that, there are two additional observations:

(1) It is true that the United States has undertaken unilateral trade liberalisation because other interests superceded impact on employment in industries affected by imports. Pettis cites this paper and the highlighted sentence is right there in the first page:

Freer trade has its costs. The record suggests that for diplomatic and national security reasons the U.S. government sacrificed thousands of domestic jobs to create employment and prosperity elsewhere in the noncommunist world. [Link]

(2) I seem to have forgotten what I wanted to write as the second point!

In reality, whether the policies help or hurt the nations practising trade restrictions is a tough one to answer. Take this delightful article on the ‘chicken tax’. America imposed tariffs on European trucks. That benefited Detroit. But, did it really benefit America? It is impossible to make out who won and who lost and over what time frame, whether we are evaluating trade liberalisation or trade protection. Further, what is the criteria? No one is sure. Each one sets up a criteria that would help them arrive at a conclusion validating their priors.

More importantly, even if one reached the conclusion, for example, that there was net employment gain to an economy arising out of trade liberalisation, there are doubtless winners and losers. Unless winners can compensate the losers, losers will become implacably opposed to trade liberalisation. That is what is happening to America.

In fact, Pettis makes that insightful point. America has probably grown tired of exporting dollars. Its debt to foreigners is rising. Two, American households have probably reached the end of their limits on borrowing to consume. Third, the losers from free trade in America are now probably more numerically than the winners and winners have not either been able to or willing to compensate the losers. The ‘inequality’ fact is too powerful now to be ignored by politicians.

So, who will win the trade war? Many have said that China is now co-opting the messy American democratic politics in its favour by targeting the products that are made in States that voted Trump. Two calculations here: one is that the American President will be forced to pay heed to electoral calculations since the November mid-term Congressional elections are at play and the second is that his constituencies would pile up pressure on him to withdraw.

But, there are dangers to this strategy. It makes an economic issue overtly political and the other side (American) can become ‘irrational’.

Also, notice two important facts mentioned in the Bloomberg Gadfly article linked just above:

Seven of the trade categories affected relate to beef, which China resumed importing from the U.S. only last year — in minute quantities — after a 14-year ban due to fears of mad cow disease. New 25 percent duties on wheat and corn won’t do much additional damage to a trade that’s minimal given the 65 percent import tariffs that China already charges on those crops. [Link] – Emphasis mine

So, did Trump start the trade war? The answer is a clear NO. John Pomfret thinks that China has lost America:

They noted that, in negotiations with then-President Barack Obama, China’s president Xi had agreed not to turn a series of manmade islands that China had created in the South China Sea into military installations. But then China did just that.

When it came to trade, they pointed out that for decades, China had been forcing American companies to hand over technology to China in exchange for access to the Chinese market. Massive Chinese espionage directly benefited the development of China’s automotive, aircraft, information technology and defense industries. For decades, Shirk noted in an interview, the American business community served as the ballast in the U.S. relationship with China. But after years of such treatment in China, she said, many American firms are “frustrated and disaffected.” [Link]

Note the comment by James Lewis that John Pomfret  cites:

China will not change its behavior absent external pressure, and pushing back against the constant drain from Chinese IP theft is long overdue. [Link]

But, of course, China betrays no nervousness on account of external pressure. A Reuter story is explicitly headlined, “China says it never backs down in the face of threats after trade salvos with U.S.” Clearly, the bully here is China and not America.

A NYT article from 5th April that is headlined, ‘Why China is confident that it can beat Trump in a trade war?’ concedes the following:

Missing in the bluster and the propaganda are the questionable methods that China has adopted to squeeze foreign companies out of key technology markets — and the fact that in the cold-eyed calculus of economics, China is more vulnerable to a trade war than officials admit.

Exports account for a big share of Chinese economic growth. Because the United States buys so much from China, Washington has many more ways to hit Chinese manufacturers. By contrast, the retaliatory tariffs Beijing has proposed already cover more than one-third of what China buys from the United States, leaving it fewer options to strike back. [Link]

Many in America, it seems, would rather see their country lose than see Trump triumph in his confrontation with China on an issue, in which the latter has been the overwhelming culprit for a long time. Just sample some of the headlines in ‘New York Times’, or ‘Financial Times’, for example: ‘America sends mixed signals’; ‘Threat to American jobs’, etc. It is a pity.

Such headlnes dominate notwithstanding this mildly worded FT Edit that calls up on China to do the right thing first.

Ironically, this attitude of the Western elite is one sign that China has understood well and exploited. That they are now more inclined to disregard larger interests for their narrow, ego-driven goals and interests. Surely, a sign of decaying society and civilisation.

They consistently fault Trump for not building an alliance against China. Well, the United States and Europe joined hands to deny China ‘market economy’ status. With respect to trade, Germany is a worse culprit these days than China with its massive trade surplus. In any case, we must remember that the issue is not so much about trade as it is about IP theft and non-compliance with WTO membership conditions on technology transfer, etc.

James Lewis anticipates the argument that Western nations routinely stole technology from each other and so why single out China?

Sometimes you hear the arguments that the United States stole technology in the nineteenth century when it was growing and that China is only doing the same. But these arguments are feeble, and those who make them are feebleminded. In the nineteenth century, it was possible to steal a book, but with digital technologies, you can steal the entire library.

The United States was a net contributor to the world stock of knowledge in the nineteenth century, and its innovations spread to other countries, given the absence of international IP protections.

In the nineteenth century, countries recognized that inadequate protection for IP hurt global economic growth and disincentivized innovation (people invest less in innovation when their work can simply be stolen). In response, they created a series of agreements to protect IP and trade in the international market. China routinely ignores these agreements, subsidizing its own growth at the cost of global innovation. China has become a country that can innovate, but it is unwilling to give up the crutch of economic espionage and will never do so unless it is pressed. [Link]

John Pomfret, in his column in WaPo, had cited the report of the Asia Society on US policy towards China, published last March (March 2017).  From the portions devoted to trade matters:

Since 2008, the business environment in China has become increasingly challenging for foreign enterprises, deeply frustrating executives with the slow pace of economic reform and official favoritism for Chinese stateowned companies and homegrown private-sector companies. As a result, China is consistently ranked far below its peers in terms of regulatory impediments and the ease of doing business.

While there have been some successes in US-China trade talks and enforcement, too many key US objectives remain unmet….

… What is more, WTO cases take years to adjudicate, resulting in critical and unfair competitive lead times for fast-growing (and often government-supported) firms. The end result is lost market opportunities for US companies. [Link]

Now, we know why China wants to go back to WTO. It would eat up precious time. In any case, if China respected WTO, it would have honoured the commitments made to the world trade body when it joined WTO.

In the final analysis, people like Richard Baldwin and the media in America and elsewhere that is happy to take potshots at President Trump and revel in his troubles – political or otherwise do not have any alternatives to offer.

Just sample what Ash Carter has to say in the interview that ‘Politico’ had with him. He was the U.S. Defence Secretary in the Obama administration:

I believe that we have no adequate economic playbook for competition with China. Last time we competed with or had a long difficult strategic relationship with a large communist country was during the Cold War, and our approach to that was simply not to trade with them. Now, one of our largest trading partners is in fact a communist country, and I don’t think that the economists have given us much of a playbook to protect our companies and our people. [Link]

Indeed, the interview itself is proof, if it were needed, that America and President Trump have to battle their own internal adversaries in their battle versus China. More than half the interview was dedicated to Russia, another 20% to 25% was dedicated to somehow getting Ash Carter to saying something negative about his successor, about the new administration and another 20% to 25% about North Korea. The comment on China was, kind of a suo moto comment by Ash Carter himself! So much for the priorities of the elites in America.

It is really Trump vs. China with Western elites on its side.

[postscript: We should remember that American tariffs do not take effect until June and China’s countermeasures will kick in only after that.]

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RBI dips into credibility balance

Quick off the blocks, Ms. Usha Thorat has written a good comment on the RBI monetary policy decision. Her last line was masterly.

As she points out in the first paragraph itself, RBI has increased the growth forecast, flagged fiscal policy risks and other inflation risks and yet, lowered the inflation forecast for the current financial year 2018-19. It is a tough one to explain away.

So, it is clear that they had set a goal for the policy meeting outcome today and worked backwards with the rationale. Of course, most human beings do that in most situations.

Frankly, there is so much uncertainty about both the growth and the inflation outcome right now for 2018-19 that one can pretty much justify any combination of projections.

Persnally, I would not set too much store by the recent uptick in some cyclical data. Hence, if I were in RBI, I would not have revised the growth projection higher.

Among the ‘forward looking’ surveys, the Consumer Confidence Survey must be a huge worry for the government. Together with inflation expectations, they present a double-whammy. Consumers are more pessimistic about their economic situation and expect inflation to be slightly higher as well! Would be a surprise if it is not reflected in the voting prefereences in the upcoming Assembly elections.

Consumer Confidence survey summary

Also, the Industrial Outlook survey (81st round) is not all that rosy. Check out Tables 15 and 16 on the availability of finance from banks and from foreign sources respectively.

Finally, one thought for the central bank’s credibility. The central bank sounded hawkish in February. Its Chief Economist keeps voting for rate increase. Suddenly, it turns soft on inflation forecast when all the logic (including faster GDP growth) points to the risk of a higher inflation rate.

But, financial markets do not call out the central bank for this ‘tangled web’ of projections. It takes them at face value and rallies! Mission accomplished! It does redound to the institution’s credibility that financial markets, instead of calling its bluff, lap up its projections and policy action.

What does it say about the financial markets, of course?  It continues to prove Eugene Fama wrong – day in and day out.

(Cheekily, I wonder if the decision,  the inflation projection, the growth projection and the dovish commentary are all a compensation for the Gandhi Nagar speech?)

Bangladesh shows the way and other links

Been a bit of a blogging hiatus due to too many visitors and grading commitments. Best way to get back is to identify articles recently read and ease back. In the meantime, thanks to the recommendation of Mr. TCA Srinivasa Raghavan, I finished reading the first of the trilogy of ‘House of Cards’ – the original.

Gulzar Natarajan drew my attention to the article in ‘The Economist’ which, in the process, rubbed India’s nose into the ground. Bangladesh had gotten a grip on diarrohea.

The ‘Wall Street Journal’ piece on Trump’s outburst against Amazon made for interesting reading. Different from the conventional response. Might be behind a paywall, though.

Manas Chakravarty has an interesting take on the philosophy behind the Modi Government’s policy initiatives. He calls it ‘creative destruction’.

A good article in ‘Business Word’ on the coincidental benefits that accrued to the venture owned by Chanda Kochchar’s husband after ICICI Bank extended a loan to Videocon. Videocon has defaulted. Investigations are on.

A good piece on how Cape Town is managing the water crisis because of three consecutive droughts. Is Bangalore ready?

Man Booker Prize changes the nationality of one of the nominees for the awards, since he hailed from Taiwan!

Jose Antonio Ocampo’s book, ‘Re-setting the international monetary (non) system’ is available for free download here (ht: Shri. Rakesh Mohan, former RBI Deputy Governor).

In the process, I came across this book. Gasp!

Why and how Finance sucked up (or, sucks up) engineering talent

I had posted the following comment in response to this article in FT:

Much of the comments on this article focused on the micro behaviour of individuals who chose to join financial institutions and hence were, for the most part, defensive about their behaviour and hence, critical of the article. But, that lens is the wrong one.

The article points to a paper that highlights the attractiveness of finance to engineers as opposed to other jobs that were more suited to their education. It is a social phenomenon and the responses have to be in the policy domain, if it is established that there has to be a policy response. As individuals, engineering graduates who joined the banking industry were doing the sensible thing for themselves and their families. This commentator and Andrew Hill would have done the same, in all likelihood. But, we need to move away from that frame.

Why did finance attract so much talent? A corollary question that poses itself is why was finance able to pay so much that talent flowed to it? Well, finance made so much of profits that it was able to pay. Actually, the attraction of talent, high wages and profits became mutually reinforcing trends later. But, what was the source of profits?

Finance, in modern times (post-1980s because that is when financial liberalisation, de-regulation and liberalisation of capital flows started in right earnest), has not been doing anything unique in comparison to the past.  It facilitated much secondary trading of financial securities. But, the compensation for it has come down considerably and the fees for active asset management have, for the most part, proven to be wasted and wasteful compensation. So, what was the source of it?

Andrew Haldane, in his contribution to the volume, ‘The Future of Finance’ published by the London School of Economics in 2010 (‘Contribution of the Financial Sector: Miracle or Mirage’) has pointed out that finance generated extraordinary profits because it wrote deep out of the money options (think Credit Default swaps and sub-prime securitisation). Deep out of the money options earns premium for the writer but once in a while these options get in the money and the writer has to pay up to the options owner. That is what happened in 2008.  Second source of profits was that much of the profits were risk-unadjusted. One source of risk is that many assets were valued as per models and hence shown at fair value. Second source of risk is high leverage ratios in investment banks’ balance sheets. The third arose out of creating products that, willy-nilly, drew the buyers into the web of financial leverage. In fact, that is where the engineering talent was needed.

High profits were required to maintain stock valuation in deference to the pressures exerted by institutional investors. Second, compensation of higher executives was linked to stock price performance. Hence, showing consistently rising profits was an obligation. That required generation of complex financial products which, though based on complex mathematics, were essentially built on unsuspecting clients assuming financial leverage. Developing these products required engineering talent. Ergo, the phenomenon that the paper and the article cover.

Now, the question for policymakers is whether any of this is welfare enhancing. Evidently, they are not. Their welfare-destruction was evident in the crisis of 2008. Have the policy responses changed the demand for engineering talent and the attraction of finance to such talent? Not much, if at all.

So, this is a socially negative phenomenon even though it is positive at the personal level, somewhat like the paradox of thrift that Keynes had discussed, in a different context.

In this context, it is worth noting that Bloomberg reported last evening that bonuses in Wall Street reached their highest level since 2006.

To be or not in the B-Index

It is difficult to keep up with Andy Mukherjee. At the rate at which he is writing, he might give Amol Agrawal of ‘Mostly Economics’ a complex with his prolificity of writing. In the last twenty-four hours alone, I have counted three Andy pieces – joining the Bond index, on the lone SELL rating on ICICI Bank and on Uber selling out to GRAB in SE Asia.

We shall focus on the column on China joining the Barclays-Bloomberg Bond index with India an onlooker. Andy thinks that India should be less fussy about foreigners holding its sovereign debt issued in Indian rupees. After all, the country runs a current account deficit and it can do with some foreign savings. Once you are in the index, index tracking funds will be invested, no matter what the fundamentals are. Of course, they can go underweight but they won’t sell and scoot fully. That is the sum and substance of his argument, if I understood them correctly.

I do not disagree with the logic. There is something to be said in its favour. Andy’s points are well made. But, on balance, I think India is not ready for it and I am not sure it will be ready in the very near future. India lacks the governance and discipline required for sustained macroeconomic stability. China can and will brazen it out. It is ‘Too big to fail’. India is not.

Whether most investors stay invested or not because of index tracking requirements, what matters to asset prices is the behaviour of the marginal investor.

Whether the debt held by foreigners is denominated in local currency or in foreign currency matters little in the end. If investors whose reference currency is not INR decide that they wish to get rid of INR risk, then the foreign exchange risk comes into play fully, regardless of the currency of denomination of the Indian debt.

India frequently gets into situations in which foreigners would want out. Despite its savings rate at a low 30%  (given its growth ambitions), India has not given up the ambition to become a high growth nation.  Governments feeling shaky politically – that may be a reality after 2019 elections – might want to go for high growth and do so via fiscal populism something that India did, not so long ago (2009 to 2011) and that is recipe for disaster for debt and for the currency because with a savings rate of 30% and low capital and labour productivity, high growth can come only via a ramp-up of aggregate demand and that would blow out the current account deficit.

The bond market – rational as they are with respect to emerging markets (only) – would administer tough love. Sometimes, it is too tough.

Bond markets are far more sanguine with respect to fiscal profligacy and debt accumulation by advanced nations. Indeed, over the last thirty five years, bond investors have rewarded advanced nations’ public debt accumulation with ever-lower interest rates. So much for market discipline!

Therefore, all told, if one is not sure of self-control and discipline and would likely binge, it is better not to look at the plate of delicious sweets.

So, India is better off not regretting missing out on the bond index membership.

The Indian banking purgatory – policy proposals – 3/3

I wrote part 2 on March 10. I have been wanting to excerpt Dr. Y.V. Reddy’s extarordinarily candid lecture on February 1st. It contained some definitive recommendations. I copy and paste them below.

In addition, he has spoken about the proximate and underlying causes of India’s bad debts problem in the banking system, etc. He is even questioning if the leitmotif for nationalisation of banks remains relevant nearly fifty years later. You should read the full speech if you are interested in Indian banking.

  1. The first step for improving our banking system is a commitment to reduce SLR and CRR to global levels as soon as possible. We cannot have a globally competitive economy with an over-burdened banking system.
  2. The current policy of ownership and governance in banking needs to be reviewed urgently to correct the outdated and distorted policies. This should be done before our banking system passes on to foreign owners, irrevocably.
  3. A high level internal enquiry within the RBI should be undertaken to fix the responsibility for excesses in NPAs in recent years and, more important, to suggest and adopt measures to improve the system as a whole.
  4. In view of the large amounts of public money involved, the government may put in public domain action taken on Fourteenth Finance Commission’s recommendation for improving the financial system with economical use of tax payer’s money.
  5. A White paper on the future of Public Sector banking may be placed before the Parliament at the earliest in view of their criticality for efficiency in financial sector as a whole, to be able to serve a globally competitive economy.
  6. In brief, the current approach of treating Banks as special and bank depositors as special must be continued, and an assurance to this effect may be extended by the Government.
  7. In view of global developments and emerging Indian economy, there is a case for RBI to internally review the current policy of annual transfer of surplus after determining the needs for addition to reserves and adopt a new policy after due consultation with Government.

The first two parts on Indian banking are here and here.

Getting off the arm-chair

These two articles remind us of where our utility as public policy commentators lies.  Real (intellectual) discoveries (epiphanies, in a way) await us when we dig deeper. The first article tells us of the author’s discovery that gun control is probably not the answer to the United States’ gun related violence.

The second story is about a Harvard Medical School study that looked into U.S. health care that is much derided.

It is a coincidence that these wo articles came into my space on a day when my column in MINT dealt with the real issue behind India’s declining Gross Fixed Capital Formation to GDP ratio. It is not, as we think, because of businesses not investing. It is because, as per official data, household capital formation has stalled. Household capital formation has stalled because household savings rate has really dropped from 25.2% in 2008-09 to 16.3% in 2016-17.

That does merit a proper investigation as to the causal factors. In my column, I allude to one: failure of the governments to provide public goods necessitating private expenditure on them. So, household savings and GFCF failure is governance failure and not ‘jobs’ failure. The column is here.