The Impact of Oil Prices and the Rise of China on US and Global Imbalances

by Nanubhai Desai: New York

There are many theories out there about what the actual causes of global economic and financial imbalances are. In differing degrees, analysts point the finger at a profligate US, or a lack of domestic demand (i.e. or excess savings) in East Asia and parts of the EU. Others point to the structural drivers of imbalances. ICT innovation and the expansion of international trade and finance are both deemed as being responsible (at least partially) for the current state of affairs. The consensus is that these imbalances cannot persist and that some corrections are in order – a rise in the value of the yuan, a fall in the dollar, a reduction in available liquidity, etc. In general, there is a prevailing view that, on account of the massive size of the US current account deficit (estimated as reaching -6.7% of GDP in 2006), what is happening now is unprecedented and a direct consequence of globalization.

However, over the past few years, another more-familiar and sinister force has been exacerbating the impact of all the factors listed above: namely, rising oil prices. Driven by increasing geopolitical angst in the Middle East, sporadic capacity constraints, but mostly by the increasing demand in fast-growing Asia – energy prices have increased almost 2.5 times between 2002 and 2006. In the US, where the average American consumes the equivalent of 25 barrels of oil each year (total consumption is about 7.5 billion barrels per year), this has meant an increase in the trade balance for oil – a major component of the US current account. On the other side of this equation, oil exporting states have by-in-large enjoyed large trade surpluses, and the petrodollars they have ‘earned’ have been invested largely in dollar-denominated assets. (Of course, sizable chunks have also been used to finance domestic real estate development, and sadly, the radical Islamists fighting America.)

Almost simultaneously, China has been on a mercantilist tear – constantly increasing its dominance of the global manufacturing industry. Large US dollar purchases have allowed China to keep the yuan low and exporting industries competitive. The dollar purchases have fueled low interest rates and consequent high consumption growth in the US, resulting in a rapidly increasing bilateral trade deficit.

These two factors alone are responsible for the majority of the deterioration in US current account deficit between 2002 and 2006 – 77% of it to be precise. The chart below breaks down the current account deficit into three components:

1. The bilateral trade balance with China
2. The trade balance in crude oil – estimated by multiplying annual net imports of crude by the average oil price for the year
3. Everything else

Over the period, the US current account deficit went from 4.5% of GDP to 6.6% (2006 numbers have been estimated using data up till Q3 2006) – a deterioration of about 2%. What we can see clearly in the chart above is that oil prices were responsible for more than half of that – or about 1.1% of GDP. We can safely assume that prices alone were responsible because oil consumption did not increase much over the period – only about 1% annually. We can also see in the chart that the trade deficit with China worsened by about 0.8% of GDP – from about $100 billion in 2002 to $235 billion today (2006 number estimated using data up till November 2006). When we net out these two components of the current account, we can see that the balance on all other items worsened by only ~0.2% of GDP over the period. Clearly, the additional money that Americans have borrowed from abroad over the last few years has been used mostly to fund purchases of two things: more expensive gasoline, and more cheap goods from China.

There are also good reasons to believe that on both fronts, we may soon see a moderation in the impact on the current account. Oil prices have eased to about $55 a gallon - $5 lower than their 2006 average. Assuming stable growth in consumption (1% CAGR) and net imports, and using the conservative assumption of 5% nominal GDP growth, we can say that for every $10 reduction in the average annual price of oil, we will see a 0.35% (of GDP) improvement in the current account deficit. To put this in perspective, other things staying the same, an oil price of $40 would imply a current account deficit less than 6% of GDP. While it might be optimistic to think this achievable this year, it seems plausible (though, in my opinion, not as yet probable) that this level can be achieved in the near future – given the recent boom in alternative energy and the push towards consolidating gasoline consumption. (This push can be seen most recently in last night’s State of the Union address with President Bush calling for a 20% reduction in gasoline consumption over the next decade.)

The trade balance with China, of course, is far more complex and unpredictable. The yuan edged up a tiny bit against the dollar last year. In the short term, this raises the cost of imports and exacerbates the deficit. However, over time, it raises the relative competitiveness of American goods and the bilateral imbalance should decrease. This year is sure to include some rumblings from the Department of Treasury about China revaluing up or moving to a managed float. And we might see some token moves from the PBOC – most likely in advance of high profile political events. However, in the end, it might be China’s own domestic imperatives that lead it towards stemming its dollar purchases and the resultant currency peg. Having acknowledged the need for a greater role of domestic demand in economic growth, Chinese leaders should now move gradually towards loosening domestic capital controls – which will mean a slower flow from the ‘savings glut’ into dollar-based securities. The yuan will rise, albeit slowly.

To be sure, recent productivity gains and continued foreign interest will keep Chinese manufacturing competitive – and the impact on the US-China trade balance will be neither immediate nor dramatic. But it seems reasonable to assume that when combined with slowing consumption in the US, we might see it stabilize, and perhaps even drop down a couple of notches.

The current debate about the driving forces behind these imbalances is largely focused on defining the global context under which they have emerged. However, the more important question to consider should be: what is so unique about them now? Because aside from the academic aspect of it, the fundamental question of imbalances is about their sustainability. It is a very fine line, but the operative question to consider should not be ‘Are current imbalances unsustainable?’—but ‘What level of imbalances are, in fact, sustainable?’

The chart below, which examines the current account balances of 150 countries over the past 25 years, paints a conflicting picture. On the one hand, if we look at the average current account balance across all countries, we see that what we are seeing now is nothing new. In the early 80s and 90s, average balances rose to over 8% of GDP – much like today. However, once we weight these individual balances by the countries’ GDPs, we see a different picture. When we look at the sum of the absolute values of these current account balances as a proportion of world GDP, it is quite clear that, this time around, something is quite different. Through most of the late 80s and 90s, this number hovered around 2%. Since 2000, it has risen to over 4% – no doubt powered by the massive deficit in the US, and the concomitant surplus in China.
Though the weighted-measure is undoubtedly a more judicious way to account for imbalances at the global level, it does not mean that average balances are irrelevant. In the chart below, one can see a close correlation between the average level of global imbalances and oil prices (the correlation coefficient is 0.47). Quite clearly, the levels of current account balances worldwide tend to rise and fall with energy prices.
In my view, the driving forces of global imbalances today are a mix of the ‘old’ and the ‘new’ – of the familiar and the unfamiliar – with each having a relatively equal role. High energy prices are the driving force of much of the imbalances today; but they are helped by another seismic structural change – the rise of China. Neither force is likely to be as strong in the next five years as it was in the last five, so it seems plausible that the imbalances could unwind a bit – with the US current account deficit coming down to 4.5%-5.5% of GDP by 2010. The question going forward is whether even that level can be sustained indefinitely. For now though, we should be content in knowing that returning to 2002 levels may be within the realm of possibility.

(Links to related articles are forthcoming)

The US Economy In Perspective

by Edward Hugh : Barcelona

The future of the US economy is a topic which is the focus of considerable debate these days, what with all the talk of hard and soft landings, customers of last resort, global uncoupling etc etc etc. In part Claus Vistesen has addressed some of the underlying structural issues in the previous post, and in part, as Stephen Roach suggests in this post earlier in the week, the future outlook for the US economy is in large measure also a question of whither the global economy, in the rather novel sense that growth in the US now depends to some significant extent on economic performance elsewhere. Indeed it is perhaps the central message of this forum that global conditions now influence national economic performance to a greater extent than has ever been the case in the past.

That being said, there is also some considerable value to be found in examining the evolution of the US economy in its own terms, to try and get a measure of where exactly it is headed, and what the general outlook for 2007 is likely to be. This is the topic I will directly address in this post, whilst a subsequent post will examine the underlying dynamic of housing, the labor market and productivity, which are arguably the three fundamental drivers of the forward path of the US economy.

With this objective in mind Ted Wiesman's Monday post on the MS GEF certainly forms a useful starting point (United States Review and Preview). Weiseman's response to the question “Is the US ‘Growth Recession’ Ending?” would appear to be an unequivocal yes, it is. In support of this view he fields a fairly impressive collection of data, ranging from last week's significantly better-than-expected international trade and retail sales reports, to a possible bottoming-out in the inventory cycle, a greatly reduced level of energy prices, and even a comparatively mild winter.

In fact the US trade balance narrowed in November from US$58.8 billion in October to US$58.2 billion, a figure which was a 16-month low, and tucked away in the data is the rather interesting detail that exports (+0.9%) increased significantly faster than imports (+0.3%). This improvement in the trade balance will, of course, impact positively on 4th quarter 2006 GDP.

At the same time retail sales have been improving, gaining 0.9% in December (with auto sales rising 0.3% and ex-auto sales rising 1.0%). Part of the picture here was a 3.8% increase in spending at petrol stations, but the general picture was also positive with sales at electronics stores rising 3.0%, general merchandise 0.9%, restaurants 2.3%, drug stores 1.2%, and furniture stores 0.7%. So there is clearly life left in the US consumer yet awhile.

The important question of course is the sustainability of this trend into the future,and here two issues loom large: housing and energy costs. On the housing front a considerable debate continues to rage. The pessimists take the view that the problem is just beginning, whilst the optimists would like to have us believe that the worst is nearly over (Dave Altig reproduces the data from the Case-Schiller Home Price Index which, as he says, does seem to offer some confirmation for the more optimistic view). Most commentators, however, do continue to point to the high level of uncertainty in this area, and I tend to concur. The incoming data are mixed, and some measures certainly suggest that the housing market is bottoming out, while others do nothing to ease the concern that another downward leg may be yet to come.

We do know that in the final months of 2006 demand for housing started to level out. Mortgage applications - for example - as measured by the Mortgage Bankers Association index, picked up both for purchases and refinancing. New-home sales, on the other hand simply stabilized, inching up from an annualized rate of 979,000 in July to 1,047,000 in November. Even if demand does remain stable at current levels, both construction and house prices could face continued weakness because of the large overhang of unsold homes - which were at a level of 6.3 months of sales for new homes in November (and this figure could yet rise if their are subsequent cancellations).

The November data indicated an uptick in home starts, but new permits continued to decline. This suggests home starts may well weaken once more after the effects of unseasonably good weather disappear. House prices may well stabilize nationwide in 2007, but the aggregate figure may mask substantial variance in local markets and in the sub-prime market, which caters to marginal buyers. Nouriel Roubini has been consistently flagging the subprime end of the picture, and the problems that this may pose should not be underestimated. Delinquency rates on subprime mortgages have already shot up, and credit spreads on sub-prime mortgage pools have widened considerably.

At the end of the day two factors seem to be important here, the inbuilt upcoming demand, and the future path of interest rates. I will comment on the former in my next post, but as regards the latter there does not seem to be any strong reason to expect any sudden and dramatic change in interest rates. Most observers seem to feel that the Fed will now be on hold for the foreseeable future, with the balance of probabilities leaning in favour of an eventual reduction rather than an increase, and of course should the housing market reveal an increased weakness in the coming quarter, the Fed does have considerable room to maneuver if it needs to try and put a floor under the market. Obviously the inflation picture is the one obvious obstacle to freedom of action on this front, but I am not especially pessimistic in this regard. Clearly global conditions will play a part in this regard, but todays decision from the bank of Japan to keep rates on hold gives us one indication of the way the wind is blowing, and as Claus and I will be arguing, there are strong reasons to think that the ECB may be nowhere near as aggressive in raising as some comentators have been imagining.

Clearly another key factor in the situation is the future path of oil prices. Today we learn that the rate of consumer inflation in the US increased for the first time since the summer (also see here) as the consumer price index rose 0.5%, driven, significantly enough, by a rise of 4.6% in energy prices. Oil futures have been falling systematically throughout the second half of 2006 driven by the expectation for rather weaker global growth in 2007, but the most recent estimates (see the IMF view here) suggest that things may not be as weak as had originally been thought (although downside surprises in both Japan and some parts of Europe may be in store, even if China and India and other emerging markets may surprise on the upside) and were this impression to be confirmed then there would obviously be a further upward pressure on oil prices which would have implications for both the US trade balance and for the US CPI.

As to the future course of oil prices things again are far from clear. Richard Berner takes (as is his normal want) the rather optimistic view that prices will be rather more resilient to upswings this time round due to the relative increase in supply capacity, but how robust this will prove to be should global economic growth remain strong throught the year really remains to be seen. And of course, we are still very vulnerable to supply shocks with geopolitical risk being as much in the forefront as ever. Serhan Cevik had a timely piece on the GEF yesterday on the risk of instability which centres on things in Iraq (and in particular, though he doesn't mention this explicitly even if it can't be far from his mind, in Turkey and Kurdistan). At the same time Nigeria is a problem which may well just be waiting to draw itself to everyone's attention).

So all in all a complex picture moving forward with lots of room for uncertainty. At this stage, barring the observation that it seems rather unlikely that the US economy is recession bound in the short term I will refrain from any explicit 2007 growth forecast, there is just too much noise in the data to be comfortable with doing this, and there are plenty of reasons for imagining that we may well have a year in front of us which is well and truly stacked full of surprises.