Odd Lots - Brad Setser on How World Trade Changed In the Last Three Years

Episode Date: June 9, 2023

A lot has happened since we last spoke to Brad Setser in April 2020, towards the beginning of the Covid-19 pandemic. For a start, Setser was appointed to be a trade advisor in the Biden administration during a period of immense disruption. There was lots of talk about a potential reshuffling of the way the global economy works, and things like nearshoring and deglobalization. But some big predictions for the way world trade will function haven't come to fruition. For instance, the US is still running a current account deficit and China is still running a current account surplus. So in this episode, Setser returns to discuss what has and hasn't changed in global trade in the last three years. He's left the Biden administration and returned to the Council on Foreign Relations, where he's a senior fellow. He talks about everything from the US-China trade imbalance to the impact of sanctions on the world economy to China's electric vehicle and plane production, plus the future of the dollar.See omnystudio.com/listener for privacy information.

Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, lists and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk, Vanguard Marketing Corporation distributor. Thanks for listening to Odd Lots. Follow the show on Amazon

Music for more future episodes or just ask Alexa play the podcast, All Thoughts on Amazon Music. Hello and welcome to another episode of the Allotts podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. Joe, can you remember the last time we had Brad Setser on? It's been too long. I don't know the exact time. I think we had him on once since the pandemic. But obviously he did his stint at the administration. So he sort of like disappeared from public view for a while. And it's just like, it's been too long without a Brad Setser episode. Well, you are absolutely right that it has been too long. But the last time we had him on the

was it was actually April 2020. So it's sort of firmly in the depths. Like right then. Yeah, right at the start of the pandemic economic experience. So that's over three years ago now. I know. And a lot has happened since then. As you mentioned, he did leave the Council on Foreign Relations CFR to join the Biden administration as a trade representative. He's since come back, which means we get to enjoy his blog posts again, his tweeting. But also, Also, setting aside Brad's personal experience over the past three years, there's just a lot that's happened with global trade, with the economy. And the weird thing is, a lot's happened, but a lot has kind of stayed the same as well. Well, so it's really well put because I think that, you know, one of the expectations during probably the last time we talked in April 2020 or middle of 2020, there's like, everyone was like, oh, near-shoring or, you know, great.

separation or and I don't think that really is the story. So on some level, I don't, you know, I do think maybe at the margins like, you know, we're still trading a lot with China, right? For all of the talk, we're still trading a lot with China. But it does feel like on the other hand, big things are changing with the nature of Chinese exports, the auto industry. And then all of these things with like EVs and the inflation reduction act and the chips act. So big things are happening on the global trade level tensions between the U.S. and the EU, big things are happening on the global trade level, even if some of the immediate predictions didn't exactly like unfold yet how people thought back then. Yeah, I mean, the U.S. is still running a current account deficit. China is still

running a current account surplus, but things are sort of changing within those broad categories. So we need to check in with Brad. We need to get his take on stuff that has changed or hasn't changed over the past three years in the global economy and global trade in the balance of payments. And I'm very pleased to say that he's going to join us now. Brad Setser, senior fellow at the Council on Foreign Relations, it's so good to have you back on the show. Thanks for bringing me back. Setting aside some of the job change that you had, what's been your impression of the past three years? Like broad stroke, what has happened? Where to begin? I mean, the world economy did.

didn't completely come to a halt in the first few months of the pandemic, but it did sort of stall intentionally. Enormous stimulus packages were passed. There was a real effort to protect people's income during the pandemic-induced slowdown. And then I think, you know, a series of shocks have unfolded after that. I don't think when the pandemic initially struck, people realized there was going to be this enormous shift in the composition of demand towards goods and away from services, which really was quite enormous. And it gummed up global trade routes for a while. There was just more demand for goods than there was capacity, even in places where we thought

there was tons of capacity. And then you have the shocks from Russia's invasion on oil markets, the closing of the pipelines to Europe. So, you know, there have been enormous shifts. But, you know, as you alluded to, the basic, some of the basic patterns of the global economy didn't immediately change. Or in some cases, they reasserted themselves more strongly. So, you know, China's trade surpluses way bigger than it was before the pandemic. The U.S. trade deficit is slightly bigger.

some of the trajectories that were probably emerging even before the pandemic. China is no longer just a location of final assembly. China produces a lot of key intermediate goods. It now produces a lot of capital goods. It's now producing and exporting a ton of electric vehicles. I think some of those trends were quite clear before their pandemic. They're now more apparent. And it's also fair to say that while it hasn't changed global trade, there is a new concern about weaponizing supply chains that's leading to policy shifts that maybe or maybe won't have a big future impact.

So what do you know, let's talk about China or the U.S. China trade relationship. You know, people have talked about decoupling, but it doesn't really seem like that. It's happened or it's happening. but there is this impulse, maybe partly for national security reasons, maybe partly for just competitive reasons, other, you know, to change the nature of the relationship. How is it different, you know, here in May 2020, versus, say, if we had been talking about this U.S.-China relationship in May 2019? Well, in May 2019, we would have been debating whether Trump was going to raise tariffs

or not raised tariffs. Oh, true. It would have been at the fight over tariffs who would have been at its. peak. I mean, I think the biggest difference now is we've largely, it's not like the tariffs have gone away, but the tariffs didn't drive as big a shift in trade as some expected. And the tools that are being employed to try to change the structure of the relationship have evolved. So, you know, the Inflation Reduction Act introduced a set of requirements for eligibility for electric vehicle subsidies that have an impact on continued use of the Chinese battery critical mineral supply chain. None of that would have been on anyone's radar screens back in 2019.

You know, EVs weren't that big. The notion that all critical materials for batteries were processed in China wasn't part of common knowledge. Joe Manchin had not determined that that was a future national security threat for the United States. Probably in 2019, it wasn't widely recognized that Intel was falling behind the leading edge of semiconductor manufacturing technology. And the vulnerabilities that were associated with reliance on TSM weren't kind of front and center. Now I think if you go to ask anyone at the NSC, what would happen if there were, a negative escalation around the Taiwan Straits, their thoughts would go quite quickly to what happens to semiconductor supplies, where that would not have been as prominent in people's thinking in 2019.

But look, the other thing, I keep coming back to this, like, China is exporting a trillion dollars more than it was before the pandemic. It's exporting a trillion dollars more than it did when Trump started his trade war. A whole bunch of large you know, kind of policy measures that were designed to make trade less attractive didn't have the effect of making China less dependent on trade. Other things, other forces had a bigger impact, the shift towards global demand for goods. The fact that, you know, the Chinese Yuan is still basically where it was, it depends on what you want to do it, but, you know, it hasn't had a lot of strength since 2014.

the evolution of the competitive of a competitive auto industry in China. All these things in the end mattered more, whether we were tariffed one-third, two-thirds, or all of our trade with China, which was the debate back in 2019. You know, you mentioned the idea that China is still very much dependent on trade, and you see that even internally from a policy perspective. We know, for instance, the Chinese economy has been a little weaker than it has been historically recently. They've been experiencing a much lower level of inflation than a lot of other places in the world. And as part of the policy response, China seems to be trying to boost supply-side support and capacity,

which will inevitably just feed into an even bigger trade surplus, despite the stated ambition of trying to build up domestic demand, shift more to a services-led economy, why does that transition seem to be so difficult? And why does it feel like China often falls back on supply-side support policies? Well, at this point, I think my operating hypothesis is that President Xi doesn't really believe in providing direct support to households. That would be the simplest, most straightforward explanation for why China, in the face of shocks that seem to call for direct support for households has not done so. The other measure, and people often talk about difficult structural reforms,

and usually they mean laying people off or cutting back on subsidies. But in China, it strangely seems to be a very difficult structural reform to change a very regressive system of taxation, move away from very hefty contributions organized through the payroll system with a big lump sum when you enter the formal labor force so that your marginal tax rate for low-income formal work is incredibly high. And to shift to a different system of tax and a system that provides a better balance of revenues between the center and the provinces and that allows more policy support for consumption. You know, demand in China was generated through investment. And there's a sense in China that handing checks to consumers doesn't generate any productive activity. It doesn't

generate any assets. It doesn't build anything. Whereas, you know, authorizing lending to through the state banks to support construction of a lot of new semiconductor or manufacturing facilities. You're obviously investing. You're obviously building things. And even if there's maybe overinvestment, you end up with assets, whereas what do you end up when you write a check to consumers other than the debt? So there's been a bit of reluctance, I would say, to, to, to, to, but.

borrow to support household consumption. There hasn't been a reluctance to borrow to support infrastructure or other investment. And so what China tends to do when the economy slows, and sometimes it slows because everyone, because Chinese policymakers worry that the debt growth has been too fast and that there's pockets of excess and some people are borrowing that won't be able to pay the money back and they clamp down and then they clamp down too hard. And then there's there's pressure to restart the investment engine. And then, frankly, over the past couple of years, there was sort of a complementarity between the U.S. and European policy response to the pandemic, which emphasized supporting

demand, supporting household income, using the government's balance sheet to insulate households from the impact of the shock, to some degree in the process, insulating firms, but a great deal of emphasis on protecting households. And then China, which emphasized maintaining its productive capacity and didn't provide much direct household income support, and China's gotten a quite substantial boost to growth over the past three or four years from net exports. So that's to me like the irony. We talk about de-globalization when on most measures China's economy actually regobilized the political debate around trade overwhelmed the discourse, but in a quantitative sense, exports as a share of GDP have gone up in China. China is getting as much of a contribution from net exports over the past four years as it got during the China shock.

China's manufacturing surplus is back close to 10 percent of China's GDP after it dipped a bit. So there's just all sorts of measures that suggest China. The overall policy response to the pandemic made the world more, not less dependent on Chinese manufacturing. But there clearly is a little bit of a reaction to that, a sense of vulnerability and a policy effort in the U.S., increasingly in Europe, to make sure that that manufacturing dependence isn't permanent and doesn't extend to too many strategic products. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy.

Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income.

So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk Vanguard Marketing Corporation distributor. Eating well shouldn't be complicated, but somehow it turns into recipes, prep, cleanup, and half your Sunday gone. Factor solves all that. These are fresh, ready-to-eat meals designed by dietitians,

delivered to your door and ready in just minutes. No prep, no cleanup, no excuses. And it's not just about convenience. You're getting real food, balanced nutrition, and zero artificial stuff. Meals that help you stay on track for all of your goals without the grind of doing it all yourself. Grilled chicken, roasted veggies, steak plates, postables. They taste like something you get in a restaurant, but they come out of your microwave in two minutes flat. If time costs or effort have been holding you back from eating better, Factor just took those off the table. Right now, get 11 meals, free shipping, and free sides for life. Hurry, this offer won't last long. Go to facturemills.ca and use code fit. That's 11 meals, free shipping, and free size for life, but only with the code fit at factoramills.ca. Factor, Canada's number one ready-to-eat meal delivery service. I don't know if there's like a really elegant way to ask this question.

How freaked out are they in Europe? I don't even think you tried, Joe. No, I was like, I was just like, how is it on my mind by what the power of the Chinese export, auto exports? Because, I mean, I feel like there was this sort of view that, well, like they were cheap, cars. They weren't really like global quality. They certainly weren't going to be like global brands and the sort of perception that China wouldn't create global brands. And my impression is that at least at the margins and maybe more than at the margins, Chinese EVs are increasingly of global quality and maybe some brand awareness, particularly in Europe.

And when you sort of factor in the lower production costs and the skill that the Chinese manufacturers have in batteries, stuff like that, like how big of a threat is this to some of the big industrial giants of Europe and the sort of business model of Europe? Well, strangely enough, at a political level, the Europeans freaked out about the inflation reduction act. I was wondering if I should go, like, which direction. I was going to, whether I should ask about the U.S. policy response or the Chinese cars. But anyway, keep going to. You know, I mean, like, in some sense, I think the U.S., you know, and, you know, the administration, which I was a part of,

had, had, was very conscious that the transition to electric vehicles should not be a transition to Chinese-made electric vehicles. Very conscious of the fact that if you're going to close down factories, internal combustion engines, you wanted there to be new factories being built in the United States to make batteries, to make the components of an electric car. And I think, you know, the U.S. had, in a sense, anticipated that there could potentially be a shock and move more proactively to manage it. Now, in the process, you introduced some measures that are debatable in their WTO consistency, subsidies that didn't extend to all of America's friends because of the way the

inflation reduction act was designed. And Europe really did display a lot of a surprise at how the Inflation Reduction Act was constructed and a lot of concern about how it was going to deindustrialize Europe. The irony to me is that there's almost no possibility any of the big SUVs or electric SUVs that U.S. manufacturers or others who are planning to make in the U.S. are going to invade the European market. They're not, they're designed for the U.S. market. They're not designed for export. And while the Europeans were complaining about the formal protection in the inflation reduction act, they had ignored the informal protection that China had extended to its

electric vehicle industry that had sort of successfully nurtured an infant industry, created a very successful supply chain for up and down the electric vehicle process, you know, batteries to drive trains, etc. And it suddenly become a big, big exporter. The Chinese did wall off their market. No, no imported vehicle ever qualified for China's electric vehicle subsidies. But they didn't do it by writing that into the law. They did it by setting up a list and no import happened to qualify. And so there has been a discrepancy, I would say, between how Europe formally has responded to the electric vehicle shock coming from China largely by complaining about U.S. policies. That said, there is undoubtedly a shift underway in Europe. The fact that VW's losing market share in China has not escaped their attention.

And the increase in imports is quite significant. And it is generating pressure on the European side to replicate some aspects of U.S. policy. But the Europeans find China a bit harder to handle because the measures that would insulate the European market from a wave of Chinese exports are likely a little bit WTO inconsistent. and the European complaint about the U.S. is that we're WTO inconsistent. So they've sort of let formalism overwhelm pragmatism. Maybe everyone can just agree to be WTO adjacent. That would be somewhat helpful for solving a bunch of trade disputes, but set that aside. So since the theme of this discussion is sort of the more things change, the more they stay the same.

I thought maybe we could talk a little bit about China debt issues. And specifically, in recent months, there's been more attention paid to the local Chinese debt. So stuff issued by municipalities, basically. And these are headlines that I can remember, you know, from 10 or 15 years ago, this idea of a China local debt time bomb. The numbers have changed. So I've seen $23 trillion. worth mentioned relatively recently. But the overall thesis is the same, this idea that eventually

these local authorities aren't going to be able to sell bonds or they're going to have to default on their debt. And the assumption always seems to be that the Chinese central government is going to step in and backstop them. So I guess my question is, is this something worth paying attention to? Why does this matter? Well, it's certainly something worth paying attention to. You know, China's central government has almost no debt by global standards. Latest, I think, numbers are about 25% of GDP. You know, U.S. and France are more like 100.

But the Chinese provinces, municipalities, localities have a very large pool of debt, direct debt. They have more direct debt, formally recognized debt than the central government. and then the local government financing vehicles, which are not, they're supported by local governments, their local government adjacent, so to speak, they have even more. So, you know, you sum those up and you get numbers of total debt above about 100% of GDP. That's not such a high level that it implies, in my view, that China is forced to do nothing except consolidate. China saves a lot. It can mobilize a lot of money through its financial system to support the government activity at various levels. But the distribution of debt is strange. It is strange that China has so little debt at the central government and so much debt at the local government. The revenue raising capacity is much higher at the central government level. It's much weaker at the local government level. And a lot of the shocks that have hit China over the past. several years have been shocks to local governments.

COVID, I mean, I was sort of surprised to read this, that the central government didn't provide large checks to local governments to cover the cost of implementing zero COVID. So a lot of that was born out of budgets. Infrastructure, financing, and expansion is done through local governments and local government vehicles. But local governments also get a lot of money from land sales. and land sale revenue has been hit by the turn in China's property market. So the weaker local governments are really in a bit of a bind.

They have limited capacity to collect revenue. Some key revenue sources have been falling. They don't get as much help from the center as probably as needed to cover their legacy debts. And it's just always harder to service debts when your economy starts slowing, even if overall interest rates are pretty low. And for some, it's going to be, it's hard to refinance in the market. So you end up, rather than having defaults, you have informal negotiations to stretch out payment. But it is a problem.

It's, you know, the investment engine of China's economy maybe had three sources, three or four sources. One is sort of, call it private investment to meet global demand for exports. One is sort of government-directed investment in key sectors aimed at import, So building a Chinese aircraft, expanding China's indigenous semiconductor manufacturing capacity, so forth and so on. But the biggest ones were building real estate for folks in China and building out China's infrastructure. And both the real estate and the infrastructure engines are now facing strain. And if you take away those engines, China's economy looks disequilibrated. it looks weak.

I want to pivot to something random. One of the reasons I like talking to Brad is I feel like I can throw things out about anywhere in the world and he'll probably have some understanding of what's going on. I want to pivot to something that I thought that was in the news recently that just popped into my head and I want to get your take on it. What is the macroeconomic significance of Saudi Arabia offering Lionel Messi $400 million a year to play soccer there? And what is a, you know, at a time of like booming EVs, I would not necessarily think this like oil giant has all this money to splash around on like a competing golf tour to the PGA and offering someone half a billion dollars a year to play some soccer games. What is going on there and how big of a force is like this money emanating out of the Saudi Arabia? State sponsored soccer. I didn't, didn't Saudi Arabia also give a contract to Rinaldo?

Oh, that's probably right. So, you know, Ronaldo messy in the desert or something like that. Look, I think what it actually means is that Saudi Arabia's current account surplus isn't going to last much longer. Oil prices have adjusted down. And oil in the 70s or 80s, now in my calculations, just covers Saudi import bill. And expensive soccer players are kind of a luxury good import, and they're the kind of luxury good import that, quickly reduces your current account surplus. So I think Saudi Arabia is heading towards at current oil prices. And if you want to build cities in the desert, sponsor global golf tours

and hire the best soccer players to come play in the desert. So they probably need air-conditioned stadiums. You're going to run a current account deficit if oil doesn't rebound back up. The Saudi's got $150 billion windfall last year, though, from their oil exports. sports. The golf countries were like generally got about a $300 billion windfall. They had been relatively conservative, I would say, over the past 10 years. I kept expecting some of the splashy policy shifts, the cities, all the other MBS investments to really change the macro numbers. And it didn't happen until the last two quarters. But I think you've really seen a big increase in Saudi spending. So Saudi Arabia structurally is either going to be drawing on

its accumulated savings, which it has a lot, or it needs somehow to orchestrate higher oil prices. So just on this note, you wrote a piece, I can't remember when exactly you did it, but it might have been one of the first ones that you wrote after you returned to CFR. But you made the point that most of these surplus countries in the world nowadays seem to be countries that may not necessarily be that friendly to the U.S. Or maybe attitudes are shifting. So places like China, Saudi Arabia, Russia would be an obvious one. What does that mean for global trade as geopolitics kind of seeps in and adds presumably some complexity to deficit surplus relationships?

Well, I did probably, probably was a conscious choice to make that one of my. first blog post because I did think it was something worth noting and something that hadn't been noticed. You know, last year, oil prices shot up and the Chinese current account surplus also increased. And the European, Japanese, Korean current account surplus either shrank in the case of Japan, swung briefly into deficit for Korea or really swung into deficit for Europe. So we were in a unique period when despite all the talk about fragmentation and limiting trade and financial flows to flows within blocks who share values who share similar political systems, all the big autocracies around the world, China, Saudi Arabia, Russia, the GCC monarchies. You know, the GCC is a bit separate because they're kind of militarily allied with the U.S. So they're – but they're kind of – at least the Saudi case, they're also a little scared of some U.S. sanctions because some – you know, MBS has a checkered history, let's say.

And clearly the political systems differ, even if there's a military alliance. So you have a world where the autocracies had surpluses. The big deficits were in the U.S., U.S., U.K. and India, democracies. And we were talking about fragmentation. There was clearly a limit to how much fragmentation is possible when all the autocracies are running surpluses with all the democracies. There is a trade flow implied by the deficit, and there is a financial flow that is also implied. So this would be like FX reserves and things like that. Well, it wasn't FX reserves.

So that's the other interesting thing is that Russia literally could not accumulate assets in its reserves. The Saudis had decided they had plenty of reserves and were. channeling money into private equity funds through their sovereign wealth fund, building up deposits, maybe getting ready to make sure that they had so much money in the bank they could pay Messi and Rinaldo in cash. And the Chinese have a longstanding now for 10 years, close to 10 years, policy of more or less not adding to their formal reserves. And instead, when there's appreciation pressure, that pressure shows up in a buildup of assets in the state banking system. And then when there's depreciation pressure, exporters just seem to hoard dollars.

So unlike in the past when you had this big buildup of foreign assets and autocracies, and you would see it in their reserves and you could track the flow back to the U.S. And, you know, people would say, oh, my God, China's buying up the U.S. Treasury market. We had implicit in this constellation of surpluses and deficits was a big flow from China, Saudi Arabia, Russia. and the other GCC countries to the U.S. and the U.K. I'm going to leave India out because we know India finances current account deficit last year by selling reserves. But you didn't see that in a buildup of reserves or a buildup in their holdings of treasuries. So it was sort of a hidden financial flow that you can infer from the global balance of payments. So I think it is interesting in a lot of ways.

One is that it just, there are so many things that happened over the past, several years in the global economy, that don't easily fit into a narrative of fragmentation into rival blocks, that don't easily fit into a de-globalization narrative, that don't fit into a de-dollarization narrative. And so this was an attempt to highlight the limits of trying to think about the world in those terms. But it was also just an attempt to say, look, there's a set of financial flows that have to be occurring through parts of the global economy that bring China's surplus to the U.S. and the U.K. without a buildup of reserves, without a formal, without obvious purchases of treasuries. And we need to do a better job of trying to understand that.

But I also look, there's a risk. And I think the risk is that we have a global economy, which has quite large financial and trade interconnections between the different bloc. and there isn't a political consensus on either part of the block that they want to maintain that level of interconnection, but it is costly to move away. So there's a tension between the world as it is and the world as someone like it to me. Eating well shouldn't be complicated, but somehow it turns into recipes, prep, cleanup, and half your Sunday gone. Factors solves all that. These are fresh, ready-to-eat meals designed by dieticians, delivered to your door and ready in just minutes. No prep, no cleanup, no excuses. And it's not just about convenience. You're getting real

food, balanced nutrition, and zero artificial stuff. Meals that help you stay on track for all of your goals without the grind of doing it all yourself. Grilled chicken, roasted veggies, steak plates, postables. They taste like something you get in a restaurant, but they come out of your microwave in two minutes flat. If time, cost, or effort have been holding you back from eating better, Factor just took those off the table. Right now, get 11 meals, free shipping, and free sides for life. Hurry, this offer won't last long. Go to facturemeals.ca and use code fit. That's 11 meals, free shipping and free sides for life, but only with the code fit at facturemeals.ca. Factor, Canada's number one ready-to-eat meal delivery service. You have the desire to aid meal delivery service?

The college, the city, you offer the program Dependance and Sententenance. Acquare the competences essential for accompany and support the people confronted to defy of health mental and of dependence. Construise a career enriching to service of the country. Don't know the health in French, it's possible with The City.

Visit the Collage, LaCitee point CA, right now. An initiative of the Consortium National of Formation in Safety in Health, supported by Santee Canada.

You know, I want to go back actually to the U.S. Europe tension, but in terms of, like, some of these things that have changed, you know, this may, this might sound like sort of like a winter 2022 question,

so maybe a little late. But maybe it made sense when electricity prices in Europe were higher. But obviously, like, there's still, I think, a sort of big long-term question mark about energy security in Europe, especially given the obvious questions about the Russia relationship. And then at the same time, the U.S. spent a lot of, you know, several years, like building up export capacity and we're like swimming in a, or floating in natural gas, maybe is the way to put it. How meaningful is this, that there's tons of cheap energy in the U.S. and is this sort of like going to be a source of marginal investment decisions to go towards the U.S.

out of Europe, this sort of further threat to the European industrial economy that can move to the U.S. and get a lot of cheap energy and there's no threat of it being cut off? It is a modest challenge to the parts of European industry. It's the most significantly it's a challenge to the German chemical industry. And there's certain other energy. intensive parts of the European economy that broadly speaking don't make sense if you have to pay really high cost to import natural gas. It makes more sense to move the industry closer to cheap sources of gas. So there's a part of, particularly German, but more broadly, European

industry that was built up around a steady supply of Russian pipeline gas at a relatively low-cost. And if that goes away, you know, in the short run, you can keep the plants running by importing expensive LNG. In the long run, you probably want to reallocate production of the most energy-intensive chemicals towards the U.S. aluminum is another one. But, like, there's a huge difference between Norwegian aluminum made with trapped hydro and some of the other aluminum factories, which are, you know, run off either gas or coal. And the U.S. ain't actually a cheap place for producing aluminum either for different reasons. But, you know, I think there's, there is a threat there.

There's a challenge to European industry coming from the auto industry, which isn't as energy intensive, coming from China. There's a challenge from Europe's very ambitious climate goals and how do you produce steel in a way that doesn't use coal. it's a challenge. But I think to Europe's credit, Europe probably more than the U.S. has thought seriously about all the changes to Europe's energy system that would eventually be needed to decarbonize the economy. It's more of a planning and more done through the electricity companies. But I think in the U.S., because we have cheap gas, there's just a tendency to think the energy security and future climate commitments can be met in the short run by burning gas and not burning coal. Whereas in Europe, there is a much stronger effort to think 20 years ahead and think of an energy system that really doesn't rely on imported fossil fuels, including LNG.

But it is a challenge. It is a threat. And the fact that Europe was paying, like, two to three times the energy equivalent per barrel of oil for imported gas just tells you how extreme the shock was. You know, you touched on this already a little bit, but one of the things that has happened recently is there does seem to be growing attention paid to the idea of de-dollarization. And to some extent, these conversations have been going on for a long time. This is also the more things change, the more they stay the same category. People have been talking about usurping the dollar's role in the global financial system for decades now. But I'm curious how seriously, if at all, you are taking some of those concerns at the moment.

Well, I guess I like pointing out ironies. And to me, the irony is we're debating de-dollarization when the best evidence is of de-euroization. And the de-URI's trade was trade that Europe sanctioned. Europe made it more or less impossible, not completely impossible, but narrowed the channels to use euros for to pay for trade between China and Europe. Russia moved away from the dollar to settle trade with China after the 1415 sanctions in Crimea. They thought it would be safer to denominate trade in euros. and then this last round of sanctions, you know, essentially showed Russia that putting your reserves in euros and putting, denominating your trade with China in euros, didn't offer significantly more protection than doing the same thing in dollars. So to me, it isn't really a de-dollarization question. It should be a move away from using G7 currencies,

question because the easy alternative for people who are worried about U.S. sanctions used to be the euro and the sanctions against Russia, which were completely appropriate. You had to do the euro or it wasn't going to be meaningful. And Russia did violate all sorts of norms, laws, expectations, name it, when it invaded Ukraine. So you should be taking steps that are bold and consequential. But cutting off the biggest Russian banks, except for Gazprom bank, from the European financial system, there's some narrow carve-outs, it's not full, but it clearly is much riskier now for China to be paying for its oil and gas from Europe and Euro.

So, you know, no shock. There's been a move towards settling that trade in Yuan. China sees the G7 sanctions and realizes that, you know, it's. insulating its economy and its ability to pay for resources, securing China's supply chains in a financial sense, will likely require greater use of the yuan in settlement. So it doesn't surprise me that we're seeing this debate now. It is a natural consequence to really significant sanctions, sanctions that in effect forced Russia to move off the euro to dominate its global trade, that showed that the euro is not a full substitute for the dollar in most purposes.

I think it's also shown that there are limits to what you can do in Yuan. It was striking to me that the Indians and Russians have spent a lot of time discussing how they're going to settle the now quite large oil trade between India and Russia. And, you know, India doesn't like the yuan. They don't have the best relationship with China. So they weren't really talking about yuan. They wanted to pay in rupee. But the Russians didn't want to build up a big rupee balance because that, you know, it isn't a global currency.

The only place you can really use rupee is to buy in India to buy Indian goods. They wanted something that was more global. So they have ended up relying still on the dollar, weirdly, and on the Emirati Durham, which is pegged to the dollar. I didn't realize this element. So it's just been this, yes, there's been a shift. Russia and China are no longer trading with each other in a currency from the rival block, or dollars, euros, or yen. But there's also been big limits on how far Russia's been able to go in moving its trade to pure yuan settlement

or pure settlement in more sanctions remote currencies. And, you know, it is funny to me that, you know, the GCC countries end up acting as financial hubs. and you denominate trade in their currency, when, you know, that is a dollar just guaranteed by their central bank. They should trade in tether. Yeah, is that your world, Joe, it's not mine. You know, actually, I want to go back to something we were talking about, you know, or you brought up with China and the sort of like the strides that they've made on some

of this advanced manufacturing. I don't remember what, you know, we've talked to several times over the years. I know that one, at least in one of those conversations, we talked about the failure of China's passenger plane industry or to build up a competitor to Boeing and Airbus. And I believe in 2023, that's still basically the case that they have not made much progress in that area. And then, of course, there's the semiconductors and obviously lots of sanctions and efforts to constrain China's ability to make advanced chips on its own. What is like going on there? This question is kind of on my mind because I was rereading a transcript of an episode we recently did with Dan Wong. But, you know, do you see like in some of these like very, like, difficult, complex industries like passenger jet?

Like, is there a change in the trajectory there? I'm hesitating because I'm honestly not sure. I mean, the C-919 has taken forever, but it is now in service. China can't build very many of them. I don't think there's yet data on their operational and fuel efficiency that will show how close they are to mapping to the 320, the 737, their main competitors. I mean, I think actually the biggest change, and this is not what on anyone's mind, has not been the C919, which has been slow. I mean, for all of China's success in electric vehicles, they've done something amazing in electric vehicles, and they've lagged expectations on aircraft. Aircraft are, I guess, harder.

China didn't have as well-developed a supply chain. The safety concerns are bigger. But the biggest shock has been that Boeing's done a, made a series of major errors. And so independent of the success of the C-919, the 737 has essentially been frozen out. out of the Chinese market. The safety concerns after the max has been hard to just hasn't come back. And then obviously it's an area where Chinese orders for new 737s are a bit of a geopolitical hostage and there just haven't been any after the trade war.

May facilitated by the fact that Boeing, you know, the max crash has provided ample opportunity for the C919 to show that it could be a. safer alternative to Boeing, which no one would have considered possible. But it also highlighted that the biggest risk that the C-919 faces is that it crashes. So I think it's made the Chinese a little bit more conservative. But it is, there is evolution there. Right now the evolution is mostly Boeing own goals, giving Airbus a big advantage and giving Airbus an opportunity, which is right now only limited by Airbus's capacity to scale up production. C-919, it will be a marginal player for a while. China doesn't have the capacity to produce that many. But maybe 10 or 20 years down the road, there will be enough capacity for that, you know, for China to have moved not only into the front of the EV transportation sector,

but also to be making inroads and aviation. You know, on chips, I have a, you know, China is not at the cutting edge. There are enormous sanctions to keep China from the cutting edge. China still produces a lot of lagging edge chips, and those chips play big rules in a lot of supply chains. So vulnerability from China is not limited to Chinese production capacity and cutting edge. And I think it will be interesting to see if some of these Chinese subsidies do generate enough capacity on some of the lagging edge chips that the lagging edge chips are cheap, and a combination of lagging chips put together can produce an effective substitute for some of the cutting edge ships.

So it's complex, but clearly, you know, when China decided it wanted to catch the technological frontier and semiconductors that caught the United States' attention, and one of the things the U.S. discovered was that it was no longer at the cutting edge of semiconductor manufacturing, not because of China, but because Intel was lagging. TSM and Samsung. And it seems obvious to me that until the U.S. is comfortable that it is back at the cutting edge, there's going to be some reluctance to allow China to move ahead too fast, in part because there are military applications that are real.

So it's become – that is one place where parts of global trade have become hostages to a geopolitical settlement. could I ask you about something that Carthic Sankaran brought up on a recent episode, which is basically, he mentioned that none of the belt and road debt that various countries owed to China is actually denominated in UN, but all of it's in dollars. Why is that? Because that would have seemed to be, you know, an obvious one for China to try to do, assuming, you know, that it wants a greater role for the UN in the system. I don't have a full answer. I find it a mystery. I find it a puzzle. I have a set of theories, but they're contingent on getting confirmation from actual Chinese sources. But my, I mean, it does, it would have made sense to have the Belt and Road in Yuan because there was a whole point. for R&B internationalization at the time. Right. It is strange that when you go into the sometimes secret loan docs, you discover they're all not only in dollars. They're LIBOR linkers with a spread, and they typically amortize after five years.

There's a certain standard structure to them. And, you know, the fact that their LIBOR linkers actually really now matters because LIBOR is quite, you know, U.S. short-term rates. rates have gone up a lot. Why in dollars? I presume because at the origin, this was an effort to recycle China's dollar surplus, its trade surplus, and to use dollars in a way that didn't add to the formal reported reserves of China's central bank. We know that was the case in some of the early first steps in the Belt and Road. There was something called an entrusted loan, which was money from China's foreign exchange reserves

that was entrusted with XM or CDB and they would lend it out and just get a spread. They would provide a service to SAFE, the holder of the reserves, without necessarily having it 100% on their balance sheets. It was clearly in dollars because it was a dollar. They'd taken a dollar from SAFE and they'd lent out that dollar and they needed to get repaid in dollars.

A lot of those entrusted loans were converted into capital and to some degree the money trail has gotten a little faint, a little harder to follow. But I think a lot of the funding for XM and CDB coming from various internal funds, some of which have support from China's reserves, probably CDB gets some swaps from someone in China, Bank of China, PBOC would be the logical ones, in dollars. So if you're taking in dollars, you've got to lend out dollars. And so it becomes necessary in order to recycle. China's global surplus. You know, Chinese reserves have been flat roughly since 2016,

so seven-ish years. During that period, the net foreign asset position of both the state commercial banks and the policy banks has probably gone up by $1.5 trillion. So if you're recycling a big surplus, someone in the economy has to be using up some of the dollars you generate and lending them out, and that mechanism of recycling in complex ways seems to have included the policy banks and the belt and road loans. That is the best explanation I can come up with, but it is a mystery, and you would think that China would have made more of an effort, not just to use the yuan to settle bilateral trade to make that trade a bit removed from sanctions, but would have made an effort to kind of make the yuan into a global currency of denomination for debt contracts.

And the easiest way would be to say that countries that wanted to borrow money from China needed to borrow a yuan. But that didn't happen. And I have one last question for me. So the last time we had you on, Tracy mentioned it was April 2020. And we were specifically talking then about the engulfing crisis that emerging markets were faced. First, obviously, just the pure like the econ shock due to everything shutting down with the pandemic, but then numerous things on top of that, including the inflation and the commodity surge, et cetera. Within the China context, I know this is not something I follow closely, but I know that like China and the rest of the world, the IMF, etc., have not been on the same page with respect to restructuring or forgiving or lessening in some way the EM debt burden. Can you explain just like what we should understand about like that gap and where those talks are?

I can try. That's probably a whole episode. Look, I guess, you know, there's a question of terminology. Most of the big emerging markets are in pretty solid financial shape. India, Brazil, Mexico, Indonesia, nothing to worry about. There's a set of what I would consider as emerging markets or some at the cutting edge of what are called front of market markets that are in a bit of trouble. Turkey, Egypt. Neither has been a big recipient of Chinese credit. Okay. They have different issues. Both have been recipients of Gulf bailout money.

Some of the Saudi surplus that didn't go to Messi and Rinaldozo did go to Egypt and Turkey, to Erdogan and Sissy. And then Pakistan, which has been a big recipient of Chinese money. So the current debate isn't around some of the bigger, more systemically important emerging economies. It's around some of the smaller economies, frontier markets that both borrowed heavily from China and borrowed from the bond market. And the basic difficulty is that these countries can't pay. They've most cases stopped paying. Sri Lanka, Ghana, Zambia have stopped paying. There clearly needs to be a restructuring.

And the Chinese and to some degree the bond market, bond investors, haven't entirely accepted the IMF's judgment on the amount of debt relief that is needed. There is no need consistent with China's preferences for China to write down the face value of their loans. But there probably is a need in some of the specific cases for XM and CDB to accept a very concessional interest rate. And there just isn't a model whereby they have. with scrutiny, with visibility to other creditors and to other borrowers accepted obviously

concessional interest rates on what they view as originally commercial loans. So that is the core impasse. That impasse, because China, because official creditors have a role to play in improving IMF lending has meant that it has been difficult for the IMF to lend after a country defaults. And because traditionally the restructuring of bilateral official credits precedes bond restructurings, the bond restructurings have been held up. So for a set of lower middle income countries, they've fallen into default. The number of countries in default keeps growing, and there aren't any exits through restructurings. So there's hope maybe that either in Sri Lanka or Zambi or Ghana, someone will come up with a model for restructuring the XM and CDB. loans. And like, people talk about China, but the bulk of the loans are from those two institutions.

And you'll find a model, a model that works, and then you can kind of move on. But right now, you know, the Chinese have been contesting every technical detail of the traditional restructuring process, whether that's because they feel like the restructuring process was designed by their geopolitical enemies and they are being forced to accept a dictat of how to restructure debts or whether because they're just stalling because their banks aren't willing to take losses. We don't know. All right. Well, Brad, I feel like we could throw out some more of the great financial mysteries of our time at you and listen to you to try to tackle them all. But we're going to have to leave it there. Thank you so much for coming back on the show. It was really great to have you.

Oh, thanks. Maybe next time we'll pick some narrower topics. Yes. We had to start. This is our jumping off. This is what happens when you go three years without him, Brad. Next time we could go there. Joe, so much to pick out of that conversation. I'm kind of having a hard time focusing on just one or two things. I did think the point about de-euroization versus de-dollarization was a really interesting one. There's no one you could talk about, you could talk to in which the conversation includes Leonel Messi, the Comax C-919, and how trade denominated in the Emirati Durham is really dollar-denominated trade. in disguise and have it all be coherent. But that's why we like turning the bread. It's true. I do think next time we need to choose one thing.

Yes. That episode we did on the Taiwanese life insurers is still one of my all-time favorite episodes. Next time we need to do a whole episode on EM debt restructuring or maybe the structure of a similar topic, but the structuring of China's belt and road liabilities. That would be interesting. And we got to do a really deep dive into Chinese. EV exports and what it's doing to the European car manufacturers in particular, because that

feels like an earthquake story, just something that I don't think was on anyone's radar a few years ago is something that could have happened. Yeah, this was a macro conversation that has led to like 18 different micro episodes to do. All right. The fuel efficiency of the C and Y9. It was not, you know, it's like where that stands versus the air, you know. I can't wait. All right.

Shall we leave it there for now? Let's leave it there. Okay. This has been another episode of the Oddlots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. Follow our guest, Brad Setser on Twitter. He's Brad underscore Setser. Follow our producers, Carmen Rodriguez at Carmen Armin and Dash O'Benett at Dashbot. And check out all of the Bloomberg podcasts under the handle at Podcasts. And for more Oddlots content, go to Bloomberg.com slash Oddlots, where we have a blog. We post transcript. and we have a newsletter that comes out every Friday.

And for more, check out our Discord. It's a really fun place to hang out and chat. People are in their 24-7 talking about all these topics. They'll definitely be talking about this episode. Discord.g.g. slash oblobs. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly.

And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about

business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plan. take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays

starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example, executives making an impact on the IHeart radio app, Apple Podcast, or wherever you get your podcasts.