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. This transcript has been lightly edited for clarity.
Key insights from the pod:
The big changes since April 2020 — 3:01
How has the US China trade relationship changed since 2019? — 5:42
Why is domestic Chinese restructuring so hard? — 9:25
How nervous is Europe about China’s EV exports? — 15:19
How big is China’s local government debt? — 20:00
What is the macro significance of Saudi Arabia’s sports investment? — 24:25
Who is accumulating the biggest reserves? — 26:48
What does energy insecurity mean for European industry? — 32:38
De-euroization versus de-dollarization — 36:07
The state of China’s aviation industry — 41:29
Why didn’t Belt and Road debt get denominated in yuan? — 46:02
The ongoing debate over EM debt restructuring — 50:26
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Tracy Alloway: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Allway.
Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, can you remember the last time we had Brad Setser on?
Joe: (00:20)
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 disappeared from public view for a while, and it's just, it's been too long without a Brad Setser episode.
Tracy: (00:34)
Well, you are absolutely right that it has been too long. But the last time we had him on the show was, it was actually April, 2020. So it's sort of firmly in the depths. Right at the start of the pandemic economic experience.
Joe: (00:50)
So that's over three years ago now.
Tracy: (00:51)
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 setting aside Brad's personal experience over the past three years, there's just a lot that's happened with global trade and with the economy. And the weird thing is a lot's happened, but a lot has kind of stayed the same as well.
Joe: (01:25)
That’s really well put because I think that, you know, one of the expectations probably the last time we talked in April, 2020 or middle of 2020, everyone was talking about nearshoring or the great separation. And I don't think that really is the story. On some level, maybe at the margins, but 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 global trade. Tensions between the US and the EU. Big things are happening on the global trade level, even if some of the immediate predictions didn't exactly unfold yet how people thought back then.
Tracy: (02:18)
Yeah. I mean, the US 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, in 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.
Brad Setser: (02:49)
Thanks for bringing me back.
Tracy: (02:50)
Setting aside some of the job changes that you had, what's been your impression of the past three years. Broad strokes, what happened?
Brad: (03:01)
Where to begin? I mean, the world economy 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 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 and oil markets, the closing of the pipelines to Europe.
So there have been enormous shifts. But you know, as you alluded to 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 trades surplus is way bigger than it was before the pandemic. The US 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 is now producing and exporting a ton of electric vehicles. I think some of those trends were quite clear before the 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.
Joe: (05:12)
So let's talk about China or the US-China trade relationship. People have talked about decoupling, but it doesn't really seem like that's happened or it's happening. But there is this impulse, maybe partly for national security reasons, maybe partly for just competitive reasons, to change the nature of the relationship. How is it different, you know, here in May 2023 versus, say, if we had been talking about this US-China relationship in May, 2019?
Brad: (05:42)
Well, May, 2019, we would've been debating whether Trump was going to raise tariffs or not raise tariffs. It would've been the fight over tariffs. That would've been at its peak. 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 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've 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 TSMC weren't kind of front and center. Now I think if you go to ask anyone at the NSC, you know, “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, 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 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 with it, but it hasn't had a lot of strength since 2014. The evolution of a competitive auto industry in China, all these things in the end mattered more than whether we were tariffed one third, two thirds, or all of our trade with China, which was the debate back in 2019.
Tracy: (08:27)
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?
Brad: (09:25)
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.
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 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, 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 Chinese policy makers 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 pressure to restart the investment engine.
And then frankly, over the past couple of years, there was sort of a complementarity between the US 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, you know, China's gotten a quite substantial boost to growth over the past three or four years from those exports. So that's, to me, the irony. We talk about de-globalization, when on most measures China's economy actually re-globalized. The political debate around trade overwhelmed the discourse but in a quantitative sense, Chinese exports as a share of GDP have gone up.
China's 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% of China's GDP after a dip a bit. So there's just all sorts of measures that 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 US, and increasingly in Europe, to make sure that that manufacturing dependence isn't permanent and doesn't extend to too many strategic products.
Joe: (14:08)
I don't know if there's like a really elegant way to ask this question, how freaked out are they in Europe about the power of Chinese auto exports?
Tracy: (14:10)
I don't even think you tried, Joe.
Joe (14:12)
No, this is just how it is in my mind. Because I mean, I feel like there was this sort of view that, well, they were cheap cars. They weren't really global quality. They certainly weren't going to be 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. How big of a threat is this to some of the big industrial giants of Europe and the sort of business model of Europe?
Brad: (15:05)
Well, strangely enough at a political level, the Europeans freaked out about the Inflation Reduction Act and didn't freak out… [about China].
Joe: (15:11)
I was wondering if I should go in that direction, whether I should ask about the US policy response or the Chinese cars. But anyway, keep going.
Brad: (15:19)
You know, I mean, in some sense, I think the US you know, and the administration, which I was a part of, 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 making 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 US had in a sense anticipated that there could potentially be a shock and moved more proactively to manage it. Now, in the process, the US 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. A lot of concern about how it was going to deindustrialize Europe. The irony to me is that there's, there's almost no possibility any of the big SUVs or electric SUVs that the US manufacturers or others are planning to make in the US are going to invade the European market. They're designed for the US 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 up and down the electric vehicle process, you know, batteries to drive trains, et cetera. And had suddenly become a big, big exporter. The Chinese did wall off their market. No imported vehicle ever qualified for Chinese 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 US 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. The increase in imports is quite significant. And it is generating pressure on the European side to replicate some aspects of US 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 US is that we're WTO inconsistent. So they've sort of let formalism overwhelm pragmatism.
Tracy: (18:45)
Maybe everyone can just agree to be WTO adjacent.
Brad: (18:49)
So that would be somewhat helpful for solving a bunch of trade disputes.
Tracy: (18:53)
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 [since then] — 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. I guess my question is, is this something worth paying attention to? Why does this matter?
Brad: (20:00)
Well, it's certainly something worth paying attention to. You know, China's central government has almost no debt by global standards. I think numbers are about 25% of GDP. You know, US 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, they're supported by local governments. They’re local government adjacent, so to speak. They have even more. So, you know, you sum those up and you get numbers of total debt of about a hundred percent 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, the central government didn't provide large checks to local governments to cover the cost of implementing Covid-zero Co. 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 gonna be 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. 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 substitution. 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 disequilibriated. It looks weak.
Joe: (23:29)
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? You know, at a time of booming EVs, I would not necessarily think this oil giant his 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 this money emanating out of Saudi Arabia...
Tracy: (24:16)
State-sponsored soccer.
Brad: (24:19)
Didn’t Saudi Arabia also give a contract to Ronaldo?
Joe: (24:23)
That's probably right.
Tracy: (24:24)
They’re cornering the market in aging football players.
Brad: (24:25)
Ronaldo-Messi in the desert or something like that. 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 in the seventies or eighties. In my calculations, that just covers the 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, you know, 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) — y ou're going torun a current account deficit if oil doesn't rebound back up.
The Saudis got a $150 billion windfall last year from their oil exports. The Gulf countries 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 desert 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 of, or it needs somehow to orchestrate higher oil prices.
Tracy: (26:06)
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 US 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, you know, deficit-surplus relationships?
Brad: (26:48)
Well, it probably was a conscious choice to make that one of my first blog posts, 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 this Chinese current account surplus also increased. And the European, Japanese, Korean current account surplus either shrank in the case of 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 GCCs are a bit separate cuz they're kind of militarily allied with the US. But they're kind of, at least in the Saudi case, they're also a little scared of some US sanctions because some, you know, MBS has a checkered history, let's say. And thenclearly 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 US, UK 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.
Tracy: (28:31)
So this would be FX reserves and things like that?
Brad: (28:34)
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 Ronaldo in cash.
And the Chinese have a long standing now for 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 in autocracies and you would see it in their reserves and you could track the flow back to the US and, you know, people would say, “Oh my God, China's buying up the US 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 US and the UK.
I'm going to leave India out because we know India financed its current account deficit last year by selling reserves. But you didn't see that in the buildup of reserves or a buildup in their holdings of Treasuries. So it's 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's 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 US and the UK 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 also 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 blocks. 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 some would like it to be.
Joe: (31:41)
You know, I want to go back actually to the US-Europe tension, but in terms of like, some of these things that have changed — and this might sound like sort of like a “winter 2022 question,” so maybe a little late — but it may, and maybe it made sense when electricity prices in Europe were higher.
But obviously, there’s still this 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 US spent several years building up export capacity and we're like swimming in 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 US and is this sort of going to be a source of marginal investment decisions to go towards the US out of Europe? Is this a further threat to the European industrial economy that firms can move to the US and get a lot of cheap energy and there's no threat of it being cut off.
Brad: (32:38)
It is a modest challenge to the parts of European industry. 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 a really high cost to import natural gas and makes more sense to move the industry closer to cheap sources of gas.
So there's a part of particularly German, but broad 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 US.
Aluminum is another one. You know there's a huge difference between Norwegian aluminum made with trapped hydro and some of the other aluminum factories, which run off either gas or coal. And the US ain't actually a cheap place for producing aluminum either for different reasons.
But I think 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 US has thought seriously about all the changes to Europe's energy system that were needed to, 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 the, you know, in the US because we have cheap gas here, 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, you know, 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 you know, 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.
Tracy: (35:29)
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 in 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?
Brad: (36:07)
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-euroized trade was trade that Europe sanctioned.
Europe made it more or less impossible, not completely impossible, but narrowed the channels to use euros for trade between China and Europe. Russia moved away from the dollar to settle trade with China after the 2014-15 sanctions in Crimea. They thought it would be safer to denominate trade in euros. And then this last round of sanctions essentially showed Russia that putting your reserves in euros and 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, it should be a “move away from using G7 currencies” question. Because the easy alternative for people who are worried about US 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 — you 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 to, you know, 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 Europe. So there's been a move towards settling that trade in yuan.
China sees the G7 sanctions and realizes that 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 re-denominate 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 rupees. 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 rupees is 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 dirham which is pegged to the dollar .
Joe: (39:31)
I didn't realize this element.
Brad: (39:34)
Yeah. So yes, there's been a shift. Russia and China are no longer trading with each other in a currency from the rival block — 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.
Joe: (40:20)
They should trade in Tether.
Brad: (40:22)
That's your world, Joe. It's not mine.
Joe: (40:25)
You know, actually, I want to go back to something we were talking about. You know, you brought up with China and the strides that they've made on some of this advanced manufacturing. I don't remember when, but you know, we've talked several times over the years. I know that, in at least in one of those conversations we talked about the failure of China's passenger plane industry 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 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 Wang. But do you see in some of these like very difficult, complex industries like passenger jets, is there a change in the trajectory there?
Brad: (41:29)
I'm hesitating because I'm honestly not sure. I mean, C919 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 [Airbus] 320, the [Boeing] 737, their main competitors.
I mean, I think actually the biggest change, and this is not 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 made a series of major errors. And so independent of the success of the C919, the 737 has essentially been frozen 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, facilitated by the fact that Boeing, you know, the Max crashes provided ample opportunity for the C919 to show that it could be a safer alternative to Boeing, which no one would've considered possible.
But it also highlighted that the biggest risk that the C919 faces, is that it crashes. So I think it's made the Chinese a little bit more more conservative. But 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.
C919, 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 in aviation.
You know, on chips, 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 roles in a lot of supply chains. So vulnerability from China is not limited to Chinese production capacity and cutting edge. And I think it'll 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 chips.
So it's complex, but clearly, you know, when China decided it wanted to catch the technological frontier in semiconductors that caught the United States attention, and one of the things the US discovered was that it was no longer at the cutting edge of semiconductor manufacturing. Not because of China, but because Intel was lagging TSMC and Samsung.
And it seems obvious to me that until the US 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.
Tracy: (45:34)
Could I ask you about something that Karthik Sankaran brought up on a recent episode, which is basically, he mentioned that none of the Belt and Road debts that various countries owe to China is actually denominated in yuan, but all of its in dollars. Why is that? Because that would've seemed to be, you know, an obvious one for China to try to do, assuming that it wants a greater role for the yuan in the system.
Brad: (46:02)
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 I mean, it does, it would have made sense to have the Belt and Road in yuan because there was a whole push for RMB internationalization at the time.
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 they're Libor linkers actually really now matters because Libor is quite, you know, US short-term 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 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 ExIm or CDM, 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 a hundred percent on their balance sheets. It was clearly in dollars because it was a dollar they had lent, 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 ExIm 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 that 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 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've made more of an effort not just to use theyuan to settle bilateral trade to make that trade a bit removed from sanctions, but would've 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 in yuan. But that didn't happen.
Joe: (49:41)
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 facing. First, obviously just the pure 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, etc. Within the China context — this is not something I follow closely — but I know that 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 what we should understand about that gap and where those talks are?
Brad: (50:26)
I can try, although that' 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 of the cutting edge of what are called frontier markets that are in a bit of trouble. Turkey, Egypt — neither has been a big recipient of Chinese credit. They have different issues. Both have been recipients of Gulf bailout money. Some of the Saudi surplus that didn't go to Messi and Ronaldo did go to Egypt and Turkey, Erdogan and others. Erdogan and El-Sisi 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 we, these countries can't pay. They’ve, in 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 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 ExIm 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. 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 low, 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 Zambia or Ghana, someone will come up with a model for restructuring the ExIm and CDB loans.
And people talk about China, but the bulk of the loans are from those two institutions. And you'll find 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're being forced to accept diktat of how to restructure debts or whether it’s because they're just stalling becausetheir banks aren't willing to take losses. We don't know.
Tracy: (53:50)
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 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.
Brad: (54:06)
Oh, thanks. Maybe next time we'll pick some narrower topics.
Joe: (54:08)
Yeah. Yes. We had to start broad.
Tracy: (54:10)
This is our jumping off point.
Joe: (54:11)
This is what happens when you go three years without a Brad episode. Next time we can narrower.
Tracy: (54:28)
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 vs. de-dollarization was a really interesting one.
Joe: (54:41)
There's no one you could talk to in which the conversation includes Lionel Messi, the Comac C919, and how trade denominated in the Emirati dirham is really dollar-denominated trade in disguise and have it all be coherent. But that's why we like talking to Brad.
Tracy: (55:01)
It's true. I do think next time we need to choose one thing. Like that episode we did on the Taiwanese Life Insurers is still one of my all-time favorite episodes. But 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.
Joe: (55:24)
And we’ve 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 was something that could have happened.
Tracy: (55:39)
Yeah. This was a macro conversation that has led to 18 different micro episodes to do. All right.
Joe: (55:47)
The fuel efficiency of the C919 and where it stands vs. Airbus
Tracy: (55:52)
I can't wait. All right. Shall we leave it there for now?
Joe: (55:55)
Let's leave it there.
You can follow Brad Setser on Twitter at @brad_setser.