Odd Lots - Lots More With Brad Setser on the Yen, a New China Shock and Excavators

Episode Date: May 10, 2024

There's a lot going on in currency markets and global trade at the moment. The Japanese yen has been falling, even after authorities seemed to intervene to try to arrest the slide. Meanwhile, weakness in the Chinese yuan has helped boost that country's exports and is fueling talk of a new "China Shock" for the rest of the world, even as its economy continues to grapple with slower economic growth and excess capacity. In this episode of Lots More, we bring back Brad Setser, senior fellow at the Council on Foreign Relations, to walk us through these developments, along with his new paper, "Power and Financial Interdependence." We also talk about what China's excavator exports can tell us about its economy.See omnystudio.com/listener for privacy information.

Bloomberg Audio Studios. Podcasts, Radio News. Brad, what's going on with the yen? Well, there's a bit of an intervention. The intervention took it from roughly 160 to 152, and now it is drifting back up towards, yes, like round 155. Broadly, the yen is just really, really, really, really weak. Obviously, that's because Japanese interest rates are very low relative to U.S. and European rates. And the end reached a level where the Japanese Ministry of Finance,

which has Japan's reserves, started selling dollars buying yen to try to limit how weak it can become. Joe, I got to say, I hate currencies. They are my most hated asset class. Why? I love currencies. No, because everything's relative. So it's like the yen is down, but is it dollar strength or is it yen weakness? It sounds like, from what Brad just said, it's more yen weakness. But I'm sure there's some someone out there who will argue that it's actually the dollar. I did a deadlift. One, two, three. Hedge.

Okay, go. What's true. GEMany. Barges. This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid impostom?

These are the important questions. Is it robots taking over the world? No, I think that like in a couple of years, the AI will do a really good job of making the oddlots podcast. And people are saying, I don't really need to listen to Joe and Tracy anymore. We do have... Cha-ching. The perfect guest.

Welcome to lots more where we catch up with friends about what's going on right now. Because even when odd lots is over, there's always lots more. And we really do have the perfect guest. You know, we had our friend Hugh Hendry on the show just this week and he was all telling this dollar story. But like, is there something wrong with Japan? Should we be scared? or is this just a natural repricing due to the interest rate differential? I mean, I don't think there is anything structurally or fundamentally wrong with Japan.

I mean, Japan obviously has had difficulty generating sustained inflation over time. And the Bank of Japan is determined to kind of get inflation up this time. And so the Bank of Japan has been, you know, running a monetary policy that's a bit at odds with the policy of the Fed and the ECB. I mean, clearly this is a case of yen weakness because you can look at the yen versus the dollar or the yen versus the euro. And either way it is weak. But it has reached a level of kind of extreme weakness. In real terms, the yen is back to its levels of the early 1970s. And so, you know, like if you think of Japan's economy in the early 1970s, that is before Japan's electronics industry took on the world, before Toyota's export.

support wave and the globalization of Japanese automakers. It's returned Japan to a level of purchasing power that does seem a bit at odds with the underlying strength of its economy. But that's, I guess, you can, you know, the debate is whether that's a natural consequence of interest rate differentials, which are large. And now there's less of an expectation that the Fed's going to cut so the interest rate differential will persist or whether the yen has overshot a little bit. reached such an extreme level of weakness that it is divorced even from an interest rate differential

that supports a weekend. So we're speaking to Brad Setser, senior fellow at the Council on Foreign Relations and someone we like to talk to to connect a lot of different things that are going on in the world. And I'm just going to ask one more question on the yen. And maybe it's sort of rephrasing Joe's question about should we be worried. But we have seen all the talk about yen intervention recently. And since that supposed intervention, it looks like the yen is weakening again. Is that something to worry about? I guess it depends on what you mean by worry. If you're the Ministry of Finance, you would rather that the yen sort of just stay in a range of 150 to 154. So if you're the Ministry of Finance, I think you are worried because the yen is

drifting back towards 160 or drifting back towards levels where you'd be expected to intervene again. The goal of intervention, some people argue the goal of intervention is to change the direction. Go from yen weakness to yen strength. I think that's an unrealistic goal, and I don't think that is Japan's goal. I think the goal of the Ministry of Finance is to limit, to set a floor under how weak the yen is. So as the yen continues to depreciate as it gets closer to 160, I think there will be increasing expectations of intervention. And in the short run, the intervention works. And I think the longer one, I mean, it works in the sense that it will move the market back towards 150. And then it becomes a question of whether the Ministry of Finance has to

continuously intervene, in which case eventually you will have a question about whether it's running out of firepower or whether the Bank of Japan needs, if it's really worried, needs to join the Ministry of Finance and adjust short-term rates in Japan as well. Tracy, can I say something that has always bothered me? And I don't mean, Brad, don't listen to this part because I'm going to question something that a professional economist say all the time. But I'm always confused and, oh, they didn't have enough inflation. They can't generate.

Like, we have inflation now in the U.S. It doesn't seem that great. Meanwhile, Japan doesn't have much inflation. I don't know. It doesn't seem that bad to me. Like, maybe just don't worry about making inflation higher. Wait, I do want to hear Brad respond to this. Look, I actually think it's a real debate in Japan.

Okay. You know, Japan's economy did function for a while. Yeah, it's functioning great. I've never been there. But every time I look pictures, it seems like a peaceful, prosperous society with great consumer and food and not inexpensive housing and working rail and all these things that we supposedly want. Like, okay, so there's not much inflation. Who cares?

I mean, it did generate some, you know, it was perceived to generate some significant problems. I mean, zero interest rates, zero inflation and zero interest rates doesn't leave much scope for monetary policy to respond to downturns. And then it makes wage adjustments more difficult. If some sector needs a reduced real wage, you have to accept weaker nominal wages. And that's just hard. And people don't like seeing the dollar or yen value of their paycheck fall. That said, I do think that there is a question about whether low interest rates in a global environment where other central banks have much higher interest rates.

And so your main transmission mechanism in theory is a weak yen about whether that's generating the right kind of inflation. in Japan. It's pushing up the price of imports. Imports in Japan feed into consumer prices. They're also an input into some Japanese industry. But in general terms, a week yen raises the cost of imported energy and food and reduces real wages, which we've seen. There was a headline yesterday about falling real wages for, you know, close to two years in Japan. And so it isn't clear that if the main effect of a week yen is reduced real wages, and you have less fewer yen to spend on Japanese services. You can't go out as much because you're spending more on imported oil, whether that will generate a healthy, self-sustaining process of appreciation.

The winners of a weak yen in Japan are the multinationals, the big exporters, some of the financial investors who have long dollar position in their portfolio. But there isn't any immediate transmission from a big company which is making more, you know, gives me more yen on its operations in Thailand and the United States to real wages in Japan to increase spending in Japan. So it hasn't yet generated the kind of inflationary dynamics that you've seen in other economies. And so I do think there is a concern. And that's why the Ministry of Finance is intervening and trying to separately limit yen weakness. There's a concern that yen weakness isn't actually helping reflate Japan's economy.

Brad, you mentioned wages there, real wages, and I was just thinking back to my wage when I was in grade school in Japan, and I used to get a thousand yen every week for my allowance, which was $10. And I have to say that exchange rate is forever fixed in my mind as like what the yen should be. It should always be around like $100 to the dollar.

And when I look at the chart now, it's really kind of stunning to me. But you also mentioned imports getting more expensive. And this is something that we wanted to speak to you about. Did you see the China export data that came out this morning? I did, yeah. So exports going up more than expected, I think it was like a 1.5% increase in dollar terms versus a forecast for 1.3%. And this has kind of burst into the public consciousness of at least finance Twitter recently, this idea that China's exports have been relatively strong. And this is one of the few bright spots, perhaps, in the Chinese economy. Can you talk a little bit more about that?

Some people are couching this as like a China shock that we should be worried about that the rest of the world will struggle to respond to. So I guess, you know, if you just look at the headline increase in dollars, an increase of one or two percent doesn't seem that dramatic. So there's another important component, which is that Chinese export prices have been falling quite significantly, you know, because of yuan weakness because of lower, you know, price war for electric vehicles, a price war for solar panels, a price war for a lot of China's exports. So export volumes are actually up more like 10%. I mean, I don't think the number is yet available for April, but that was certainly the case for the first quarter. And so it is in that context that one can think of a new China shock. I think that the notion of a new China shock is very much tied to the auto sector and both the electric vehicle sector and traditional combustion engines where China has gone from basically being a source of import demand. I mean, China imported high-end luxury cars from Germany, not so many from Japan, but that's, A few from Japan, a lot from Germany.

And five years ago, it wasn't a big exporter, not of cars. Produced some trucks for export, but not much. Past few years, that's changed. China's now the world's biggest exporter of cars. Its electric vehicle manufacturers are exceptionally competitive. They're taking market share from the foreign joint ventures in China, and they're really starting to try to export. And then some of the old capacity that made traditional internal combustion engine

cars in China is being repurposed to serve global demand. So this is just combining to really push up export volumes in autos in an important way. There's also just enormous capacity inside China to produce solar panels, to produce batteries. And so, you know, China can meet global demand for these products as it expands out of its existing capacity, which is, It makes it very difficult for other countries who want to build up their own solar industry or their own battery industry to get those industries going. I think that's the sense in which China's exports are a bit of a shock to the global system and why there's been a bit of pushback.

There's some technical factors as well. We all remember that during the pandemic, everybody bought a lot of computers, bought a lot of household appliances that drove China's exports up to a really, really high level two years ago. They kind of dip back down and now they're coming back up. But there's a dynamic around China's traditional exports. And then there's a separate dynamic around cars and clean energy exports. And I think the China shock is much more now around cars and clean energy. You know, I remember in the post-2010 environment and there was a lot of talk about, you know, currency wars. And this idea, everyone doing this beggar thy neighbor policy of trying to have

their currency weaker so that they could sell more? Is that still a dynamic because the yen can keep falling, but it doesn't mean they're going to have a national BYD. In fact, Toyota isn't even really that into EVs as far as I can tell. Or the Malaysian ringet is pretty weak, but they don't have a BYD either or a Xiaomi or a Comac or whatever it is. Like how much do currencies today play and trade competitiveness or in an environment in which the big source of action, seems to be non-commodity, more cutting-edge technological exports? I'm super retro on this question. Okay.

Currencies, in my view, still matter. They matter. There's our headline. Ooh, I'm really going out on a limb there. Look, I think the response of Japanese exports to yen weakness has been relatively modest. I think there's a lot of different reasons for that. I think Toyota has wanted to protect its transplants, its factories in the United States. United States. It hasn't wanted to engage in a price war. It has preferred to basically take the

weak yen as a source of greater profit rather than really engage in a fight for volume. If you look at the weak Korean won, which is also very much. Which I was going to bring up because it sort of shows that there is this commonality. It's not just a yen story. But yes, anyway, keep going to. Any case, you know, if you look at Hyundai sales in the U.S. and their exports to U.S., they've responded very clearly to the week one. You know, there's been an enormous. actually increase, hasn't gotten a lot of attention in Korean auto exports to the U.S. And I also think the fact that in real terms, because Chinese inflation has actually been very low relative to inflation in the rest of the world, and the yuan has come down against the dollar.

You know, there's been a roughly 10% weakening of the yuan in real terms. And I think that is one of the factors that is contributing to this export boom. You see all these comparisons of China's EV prices versus prices of EVs elsewhere. And of course, part of that is just, you know, BYD got really good at making EVs really fast. Yeah. But part of it is that the Chinese yuan is below where it was 15 years ago against the dollar. And inflation differentials are now bringing cost in China down. My rule of thumb is that if the Chinese yuan is not going up, if it's not appreciating, China tends to gain global market.

share. And I think that is a general rule that's held over time. And I think it's asserting itself now. The interesting thing about China is that it is not giving up its old competitive advantages, as it is introducing these new advantages. It's just exporting more. And I think that is in part a function of the weak yuan. So there's been some weirdness. Certainly a lot of relationships broke down during the pandemic. But my baseline thesis is that you're going to see a reassertion of the traditional well-established relationship between currency values and export volumes pretty clearly over the next couple of years. Wait, this is my chance to ask you about Chinese excavators and what they maybe say

about what's driving the export boom and the debate between, you know, interest rate differentials and maybe currency contributions versus excess capacity, because that's the other thing that people are talking a lot about, this idea that, well, there's so much excess capacity in the Chinese economy, if you can't sell into your domestic market, then you're going to try to sell more outside of it. Look, the reality is those factors tend to go together. If you've got weakness in your domestic market, you're going to have low interest rates and a weak currency as a general rule. And that exchange rate signal helps you take process. that previously were produced for your own market and sell them to the rest of the world.

They're not mutually exclusive explanations. A weak currency helps you take excess capacity and sell it globally. There's two different things that have happened with excavators, which are like the big construction equipment with like a backhoe that helps you dig out the foundation of a new building or help build a road. They're like the base construction equipment. you know, in the U.S. would be like the thing Caterpillar makes. Yeah. It's the thing that every guy I've ever met always dreams of operating. Because they're cool.

I mean. Exactly. By the way, wait. So on this point, sorry to intervene, but on this point, Tracy, you know I'm going to Las Vegas next week to see Dead and Co. With a few friends at the sphere. And we're looking at a few of the things that we can do. Like we're going to go see the big dam that's out there and other stuff.

one of the things that possibly will be on our itinerary is this big amusement park where adults and kids can dig up stuff with excavators. What a business model. You may get a picture of me in about a week from today sitting in an excavator or in the bucket part of it. Anyway, so yes, confirmed. All right. And in my youth, I think I had a Lego set where you had like the fancy gears and you could like make it move and it was an excavator and it was the coolest. There's something amazing about the mechanics of an excavator. But, you know, two things have happened.

Like, 20 years ago, there were a lot of excavators made in China, even then. Those excavators were often made by Caterpillot or Komatsu, the big Japanese construction equipment company. And so over the past 20 years, Chinese companies have sprung up, developed, been able to produce at a lower cost point, probably gotten a little local preference. You know, if you're a state-back construction company, you're probably going to use a Chinese excavator if it is price competitive. And so inside the Chinese market, the Chinese companies, the Chinese marks have gained at the expense of foreign companies. And then the second thing that happened is that as China went through, you know, one of the world's biggest property booms, there was just a lot of demand for excavators.

So capacity increased. and China was producing a lot of excavators. Chinese companies were producing a lot of excavators that were mostly being used in China as part of the construction boom. Construction boom turned to construction bust. Chinese companies are making competitive excavators and guess what?

Those excavators are being exported globally. Same dynamics a little bit in steel. So it is not just a clean tech EV dynamic. The set of inputs, old industry, inputs into construction, you know, construction activity in China is down. It's going to go down further, given all the difficulties in the property development sector and given the fact that China is overbuilt and you're going to have to have an extended period of much reduced property construction. Those inputs are in some small part being exported. I mean, China could export

more steel, but Chinese steel exports now exceed U.S. steel production. I think they exceed. see Japanese steel production. Wow. I mean, that's just a, and that has not exhausted Chinese export capacity. There's still capacity to export more. So that's the kind of thing that makes a lot of China's trading partners nervous. You know, China can export 100 million tons of metric tons of steel and still export another hundred million. China's exporting five million vehicles, but there is clearly capacity inside China to export

10. And, you know, five is more than Japan. It's more than Germany. Ten would be record breaking. So it's that forward-looking concern is very real. Tracy, two things. I'm on olibaba.com right now. And there's apparently excavators you can buy for $2,000 from China. I don't understand how that has to be a mini, many. Yeah, but they look like something. But then the other thing is like, you know, Tracy, I just had this lightball moment where, you know, when the internet bubble happened in the U.S. Everyone was like, well, yeah, but there were some good spillovers because we got all this unused fiber optics and it laid the groundwork for the next 20 years. China real estate bubble creating this incredible unused capacity of excavator and know how to make excavators

for the rest of the world. So there you go. Okay. Brad, the other thing we wanted to ask you about, we could just turn this into an excavator episode. Well, we got to get that guy on TikTok who sells the Chinese excavators in the layout sometime. That would be fun. Brad, the other thing we wanted to ask you, and this kind of ties into the discussion around, well, it very much ties into the discussion around China's export boom. You just published a paper at the French Institute of International Relations called Power and Financial Interdependence. And you're sort of tackling this idea of the China and U.S. financial systems being intertwined. So China buys a lot of U.S. treasuries because it has to, basically, because it's exporting a lot to the U.S.

But you make the point that there's a difference between financial intertwining or interdependence versus the sort of real economy interdependence. Could you talk a little bit more about that? Well, I mean, I think the paper has an ambitious title. So hopefully people will read it as a paper with some ambition, even if the conclusions are nuanced. I guess I make a number of different observations about the link between financial interdependence and real economic interdependence. One is the one you made that if there is an enormous trade imbalance, by definition, there has to be offsetting financing and there will be a financial imbalance, even if that imbalance is a bit hidden and even if it is hard to trace.

And one of the clear trends over the past 15 years is that China has gone from, more or less, taking its export surplus, having the central bank buy it up, buy up the dollars, in investing in treasuries or in agencies to doing a lot of more diverse things with its foreign exchange reserves. There's a phrase that safe uses, which I like called the diversified use of foreign exchange reserves, which actually it would be putting them into financial assets that are in no way foreign exchange reserves. And then because of low interest rates right now, the accumulation of financial assets on the Chinese side has moved to the exporters to the private side of China's economy. And so it doesn't show up as this huge sustained bid for treasuries.

So that's kind of one theme. The other theme is, hey, if you're thinking about the exercise of power, there are conditions when you really need financial assets. If you have an overvalue currency and you want to defend that currency, you don't want the currency to weaken, or if you have foreign currency denominated debts that you really want to pay, you need financial assets and losing access to financial assets can be a very powerful sanction. But China, by and large, doesn't need access to its legacy financial assets to do much of anything right now. You know, it's got this big ongoing trade surplus. It doesn't have much foreign currency external debt. Obviously, it does help with respect to intervention. But if at the end of the day, the worst outcome that for

China from losing access to your foreign exchange reserves is a weak Chinese yuan, that's probably something China can manage, actually. Conversely, those countries that are selling financial assets to China, they're receiving real goods and services, mostly goods. And if you lose access to real goods in a crisis, in certain contexts, that can be quite devastating. You lose access to imported components and then the rest of your production process. can't continue until you find an alternative source. And for some products, there is no alternative source that's also not Chinese. So I think you have to worry a little bit in a world where, you know,

so-called interdependence has been weaponized. And the U.S. has weaponized interdependence, chip export controls are the classic example, financial sanctions or the other. China has weaponized interdependence, economic coercion, not buying commodities, or at least some commodities, or commodities from countries where it don't say nice things about China, you know, famously with Australia, or squeezing Korean automakers after Korea agreed to the deployment of a powerful U.S. radar in Korea. Or losing access to Chinese tourists because the Chinese State Tourism Bureau doesn't sell package holidays to your country if you're not saying if you're rude and mean to the Chinese people.

So, you know, there are various ways in which interdependence can be weaponized. And some of those involve limits on the use of your foreign assets, financial sanctions. And some of those involve restrictions on the real flow of goods. And I think in the most extreme scenarios, the restrictions on the real flow of goods may be more significant for the Sino-American leverage than financial. Right. That's basically my takeaway here, that if the U.S. did to China, at some point in the future what it did to Russia, which I'm not even sure of that was that effective against Russia, but against China, it wouldn't have a big impact necessarily, but if the China converted, conversely did the opposite, it would have a big impact on us.

So it seems like a bad situation for the U.S. Well, but to be fair, one of the side effects of the property boom in China, you know, Xi Jinping has this idea that he can reduce his dependence on the rest of the world by substituting out all the goods that China now imports, at least the manufactured goods that China imports, and building up stockpiles of all the commodities that China imports. And so if there was a big interruption in trade, China's economy could continue to function. Fair enough. One thesis, it's a pretty aggressive thesis. It's aggressive in the sense that it's preparing for a negative contingency. It's aggressive in the sense that it engineers

out all of other countries exports into manufactured exports into China. But it doesn't change the fact that an enormous part of the Chinese economy and a growing part of the Chinese economy, all the people making excavators, for example, or internal combustion engine cars for export, their jobs depend on access to export markets. So China's dependence on external demand has gone up very, very significantly over the past three or four years, even as China's reliance on imported manufactured inputs has gone down. So China does have its own very significant vulnerabilities in that respect. We're back to excavators as the prism through which to understand China's economy.

Lots more is produced by Carmen Rodriguez and Dashel Bennett with help from Moses Ondom and Kale Brooks. Our sound engineer is Blake Maples. Sage Bauman is the head of Bloomberg Podcasts. Please rate, review, and subscribe to Oddlots and Lots More on your favorite podcast platforms. And remember that Bloomberg subscribers can listen to all of our podcasts ad-free by connecting through Apple Podcasts. Thanks for listening.