Thoughts on International Finance, with Application to the US and China

(I wrote this back in 2020, and never posted it. The context is different now, but the substance still seems valid.)

Here is my mental model, for whatever it’s worth:

(1) The US-China trade balance is determined in the short to medium run by relative income growth in the two countries. In the medium to long run relative prices do play a role. But at least past the early stages of industrialization, the impact of exchange rates is thru producer entry/exit than thru expenditure switching. The impact of the overvalued dollar of the early 80s came mainly through e.g. the bankruptcy of US steel producers selling at world prices, rather than a loss of market share from selling at US prices.

(2) Chinese capital controls limit cross-border financial flows. This especially limits the acquisition of foreign assets (including real estate, consequentially for New York) by Chinese firms and households. This implies greater net inward financial  flows than there would be in absence of controls. This is probably the most important Chinese policy with respect to cross-border flows — a broad liberalization would be more likely to push the renminbi down than up.

(3) The Chinese central bank passively accumulates/decumulates whatever level of reserves are implied by the combination of 1 and 2.

(4) The exchange rate is either chosen by one or both governments or determined in speculative markets. (In practice this means the Chinese government, but there’s no in-principle reason why this has to be so.) There is no meaningful link from the trade balance to the exchange rate, and at most a weak link from the exchange rate to the trade balance. Exchange rate interventions are not an independent factor in reserve changes. 

(5) The interest rate on US Treasury debt is determined by some mix of Fed policy and self-confirming market expectations (convention). Chinese reserve purchases play zero role. 

(6) US deficit spending is not constrained, required, or influenced in any way by foreign reserve accumulation. When desired foreign reserve accumulation departs from new Treasury issues, the gap is accommodated by net sales between foreign central banks and the private sector.

(7) If a mismatch between the supply of Treasury issues and the demand for reserve accumulation creates pressure anywhere, it will be on private assets that are close substitutes for Treasuries. In particular, it is plausible that insufficient federal borrowing in 1990s-2000s helped create the mortgage securitization market. 

(8) Returning to exchange rates. The fact that import price elasticities are low, and that most trade is priced in dollars, means that exchange rates affect trade mainly via exporters’ profit margins. An appreciation can undermine exports, but this is a slow process of failure/exit by exporters, and thus strongly depends on financial capacity of exporters to operate with diminished margins. So for instance the large, roughly symmetrical movements in the dollar-yen exchange rate in the first and second halves of the 1980s affected the US tradable sector more than the Japanese, because Japan’s bank-based financial system plus the lack of shareholder pressure made it easier to sustain losses for extended period there than in the US.

In the textbooks, we get a picture of a tightly articulated system where a change in behavior in one place must lead to an exactly offsetting change somewhere else, mediated by price changes. Given a set of fundamental parameters, there is only one possible equilibrium. The considerations above suggest a different vision.

In the orthodox vision, international trade and financial flows are like a pool of water. If you drop a rock in, the whole surface of the pool rises by the same amount. Of course there are passing ripples. But knowing what level this part of the pool was at a while go doesn’t tell you anything about what level it is at now. One could, though, just as easily imagine a pile of rocks. When you move one rock, it normally affects only the rocks in the immediate vicinity. And the same rocks can be piled up in many different ways; where they are now depends on where they were before.

From where I’m sitting, there are three major sources of flexibility in the international system, all of which undermine any claim that shift in one flow must lead to equivalent shift in some other flow.

First is the existence of passive, accommodating positions that act as buffers. Central bank reserves can function this way; this is accepted in mainstream theory. But so can bank loans and deposits, and positions taken by fx specialists. In the short run, bank deposits are always accommodating buffers for any other flow.

Second is speculative price dynamics that make asset demand endogenous to current price. Concretely: If an asset is held largely in hope of capital gains, as opposed to yield or use in production, and if there are anchored expectations of normal or long-run price x, then any position that produces a price move away x implies capital gains for anyone who takes the other side of the position. In markets where these kinds of speculative dynamics operate – and I think they operate very widely – then even large changes in flows don’t have to lead to significant price adjustments. (Conversely, shifting expectations can lead to large price changes without any shift in flows.)

Third is the fact that trade adjustment happens mainly thru entry/exit rather than expenditure switching in product markets. This means in effect that the balance sheets of exporting firms act as shock absorbers. Let’s say that a country’s financial assets become more desirable to global wealth owners, causing a financial inflow and (plausibly though not necessarily) an appreciation of its currency. In the textbook story, this leads to an equal and immediate fall in net exports. But in reality, with exports priced in global markets, the immediate effect is a fall in the profitability of exporters. Only over time, as those firms go bankrupt or give up on export markets, will trade volumes change.