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

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1:37Bloomberg Audio Studios. Podcasts. Radio. News. Brad, what's going on with the yen? Well, there's been a bit of an intervention. The intervention took it from roughly 160 to 152. and now it is drifting back up towards, yes, like around 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 yen 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.

2:23They are my most hated asset class. 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 someone out there who will argue that it's actually the dollar. I did a deadlift. One, two, three. Hegemony. Okay, good. Hegemony. 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 ink pasta? These are the important questions.

3:00Is 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 Outlaws podcast. And people will say, 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 OddLots 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?

3:39Should we be scared, or is this just a natural repricing due to the interest rate differential? I mean I don't think there's 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 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.

4:18But 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 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 wave and the globalization of Japanese automakers. It's just – 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 – 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 is going to cut so the interest rate differential will persist or whether the yen has overshot a little bit.

5:09It's reached such an extreme level of weakness that it is divorced even from an interest rate differential that supports a weak yen. So we're speaking to Brad Setzer, 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?

5:51I 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.

6:33So as the yen continues to depreciate, as it gets closer to 160, I think there will be increasing expectations of intervention. And, you know, 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.

7:13Tracy, 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 professional economists 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 US. 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. You know, Japan's economy did function for a while.

7:48Yeah, it's functioned. I've never been But every time I look pictures, it seems like a peaceful, prosperous society with great consumer and food and inexpensive housing and working rail and all these things that we supposedly want. Like, OK, so it's not – there's not much inflation. Who cares? I mean it did generate some – 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.

8:32And 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 weak yen raises the cost of imported energy and food and reduces real wages, which we've seen.

9:13There was a headline yesterday about falling real wages for close to two years in Japan. And so it isn't clear that if the main effect of a weak 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 – it gives me more yen on its operations in Thailand and the United States to real wages in Japan to increase spending in Japan.

10:04So 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 1 ,000 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.

10:46It should always be around 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.

11:30Can 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 1 % or 2 % 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 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 percent.

12:09I 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 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.

12:51Past few years, that's changed. China is 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 China can meet global demand for these products as it expands out of its existing capacity, which 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.

13:51I 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 dipped 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.

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15:59Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokered services for U.S.-listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. 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.

16:39Is that still a dynamic? Because the yen can fall, 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 Ringgit is pretty weak, but they don't have a BYD either, or a Xiaomi, or a Comac, or whatever it is. How much do currencies today play in 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.

17:18Ooh, 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. 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 – Which I was going to bring up because it sort of shows that there is this commonality. It's not just a yen story.

17:56But yes, anyway, keep going. If you look at Hyundai's sales in the U.S. and their exports to the U.S., they've responded very clearly to the week one. There's been an enormous actually increase. It 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, 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.

18:35You see all these comparisons of China's EV prices versus prices of EVs elsewhere. And of course, part of that is just BYD got really good at making EVs really fast. 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.

19:20It'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 interest rate differentials and maybe currency contributions versus excess capacity?

20:04Because 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 products that previously were produced for your own market and sell them to the rest of the world. They're not mutually exclusive explanations.

20:42A wheat 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. In the U.S., it 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. Exactly. You just made my point. 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.

21:21with 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. Go, Brad. And in my youth, I think I had a Lego set where you had the fancy gears and you could make it move. And it was an excavator and it was the coolest.

21:57There'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 Caterpillar 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-backed 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.

22:40And then the second thing that happened is that as China went through 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.

23:28It'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 US steel production. I think they exceed Japanese steel production. I mean that's – it'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.

24:07China can export 100 million tons of metric tons of steel and still export another 100 million. China's exporting 5 million vehicles, but there is clearly capacity inside China to export 10. And, you know, 5 is more than Japan. It's more than Germany. 10 would be record-breaking. So it's that forward-looking concern is very real. Tracy, two things. I'm on Alibaba.com right now. And there's apparently excavators you can buy for$2 ,000 from China. I don't understand how the price is. That has to be a mini excavator. Yeah, but they look like something. But then the other thing is like, you know, Tracy, I just had this light bulb moment where, you know, when the Internet bubble happened in the U.S., everyone is 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.

24:59China 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. We got to get that guy on TikTok who sells the Chinese excavators in LA 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.

25:36And 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.

26:20One 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.

27:05And 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 overvalued 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.

27:44And 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. 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 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.