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

30:22So you have a world where the autocracies had surpluses. The big deficits were in the 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 has to be – 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.

30:58The 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 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.

31:37So 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 people would say, oh, my God, China is 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 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.

32:16So 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 deglobalization narrative, that don't fit into a dedollarization 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.

33:06and 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 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.

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34:44It's one of the many ways Wells Fargo seeks broad impact in communities. Wells Fargo, the bank of doing. Learn more at wellsfargo.com slash say do. Support includes contributions from Wells Fargo and Company and the Wells Fargo Foundation. 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 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, 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.

35:30And then at the same time, the US spent a lot of several years building up export capacity and were swimming 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 is a challenge to the German chemical industry.

36:09And there's some 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, 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.

37:00Aluminum is another one. But 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 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. You know, 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.

37:41But 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 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, you know, 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, you have to – 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.

38:30So – 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. 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 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.

39:17But 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-euroized trade was trade that Europe sanctioned. Europe made it more or less impossible, not completely impossible, but narrowed the channels to use euros to pay for trade between China and Europe. Russia moved away from the dollar to settle trade with China after the 14-15 sanctions in Crimea. They thought it would be safer to denominate trade in euros.

40:06and 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 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.

40:59So 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 no shock. 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.

41:44So 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 denominate 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 India doesn't like the yuan. They don't have the best relationship with China.

42:25So 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 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. uh russia and china are no longer trading with each other in a currency from the rival block dollars euros or yen uh but there's also been big limits on how far russia has been able to go in moving its trade to pure yuan settlement or pure settlement and more sanctions remote currencies.

43:21And, 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. That's your world, Joe. It's not mine. You know, actually, I want to go back to something we were talk about, 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.

44:11And 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? Like this question is kind of on my mind because I was rereading a transcript of an episode we recently did with Dan Wong. But what 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.

44:51I mean, the 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 320, the 737, their main competitors. I mean, I think actually the biggest change, and this is not what is 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.

45:39The safety concerns are bigger. But the biggest shock has been that Boeing has 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 have considered possible but it also highlighted that the biggest risk that the C919 faces is that it crashes.

46:33So I think it's made the Chinese a little bit more conservative. But there is evolution there. Right now, the evolution is mostly Boeing-owned 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.

47:19You know, on CHIPS, I have, 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 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 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 chips.

48:03So 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 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 TSMC 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 that is one place where parts of global trade have become hostages to a geopolitical settlement.

48:52Could 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 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 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.

49:54It 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 the fact that they're LIBOR linkers actually really now matters because LIBOR is quite, 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's central bank. We know that was the case in some of the early first steps in the Belt and Road.

50:46There 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 sheet. So it was clearly in dollars because it was a dollar. They had taken a dollar from SAFE and they 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.

51:22But 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, 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 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.

52:07So 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.

53:00And 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 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, et cetera, have not been on the same page with respect to restructuring or forgiving or lessening in some way the EM debt burden.

53:39Can 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 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 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.

54:22Some of the Saudi surplus that didn't go to Messi and Ronaldo did go to Egypt and Turkey, to Erdogan and others, Erdogan and 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 – most cases stopped paying. Sri Lanka, Ghana, Zambia have stopped paying. There clearly needs to be a restructuring.

55:09And the Chinese and, to some degree, the 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.

55:54That impasse, 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 XM and CDB loans.

56:36And people talk about China, but the bulk of the loans are from those two institutions. Got it. 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 diktat 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 try to tackle them all.

57:19But 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. Thanks. Maybe next time we'll pick some narrower topics. Yes, we had to start jumping off. This is what happens when you go three years without a Brad episode. Next time we can go.

57:47Joe, 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-euro-ization versus de-dollar-ization was a really interesting one. There's no one you could talk to in which the conversation includes Lionel Messi, the Comax C919, 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 Tony Nebra. 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.

58:30Next 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 like 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 sea and why not?

59:08It was not – it's like where that stands versus the – 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 Odd Lots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Weisenthal. You can follow me on Twitter at The Stalwart. Follow our guest, Brad Setzer, on Twitter. He's Brad underscore Setzer. Follow our producers, Carmen Rodriguez at Carmen Armin and Dash O 'Bennett 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 transcripts, and we have a newsletter that comes out every Friday.

59:48And for more, check out our Discord. It's a really fun place to hang out and chat. People are in there 24-7 talking about all these topics. They'll definitely be talking about this episode, discord.gg slash OddLots. Thanks for listening.

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