Weekly global economic update

Week of February 26, 2024

• The US office property market could create challenges for the Fed
• China’s residential property market could have a global impact
• Foreign investment in China falls sharply
• Eurozone inflation eases, but problems remain

The US office property market could create challenges for the Fed

• The US Federal Reserve has been given a dual mandate by the US Congress. It is charged with minimizing inflation and maximizing employment. Yet the Fed is also responsible for regulating banks and ensuring financial stability. The Fed is likely concerned that, having increased interest rates substantially in the last two years, it has added to stress in the already troubled office property market. This creates the risk that the Fed will need to address financial stability rather than inflation.

Here is the problem. Not enough people are returning to office work, often preferring to work at home. The result is that, for many companies leasing office space, there will likely be a decision to downsize when leases mature. When that happens, office building owners will face a loss of revenue, potentially leading to defaults on mortgages. Indeed, the delinquency rate on office building mortgages is now 6.5%, up dramatically from a year earlier. The prospect of further trouble has already led to a decline in office building valuations. That, in turn, means greater difficulty in rolling over existing mortgages. Moreover, with interest rates now significantly higher than a year ago, refinancing becomes that much more difficult.  

Here are a few figures: This year, the volume of commercial real estate (CRE) loans maturing in the United States will be US$929 billion, or about one-fifth of the outstanding volume of loans. This includes not only office but other types of commercial property. Of this, about one-third were due last year and were renegotiated. About half of this volume is held by banks and about one-quarter is securitized. The rest is held by insurance companies, credit companies, and others. Of the loans held by banks, a disproportionate share is held by small banks for which CRE loans are equal to twice their Tier 1 capital. For large banks, CRE loans are equal to half their capital. Thus, smaller banks, of which there are about 2,000 in the United States, are at greater risk. Still, for large banks, non-performing CRE loans now exceed loan loss reserves. Moreover, if, as expected, delinquencies increase in the coming two years, then even large banks could face increased financial stress.

From the perspective of the Federal Reserve, where the top priority is to tame inflation, the troubled office property market is a potential challenge. Indeed, when Silicon Valley Bank failed last year, the Fed had to pause its monetary tightening and inject liquidity into the banking system to avert a systemic crisis. A crisis was averted and the Fed was able to return to inflation fighting. Yet if, in the coming year or two, there are multiple failures of small- to medium-sized banks, the Fed will be compelled to intervene massively. It will likely encourage larger banks to acquire smaller banks while the Federal Deposit Insurance Corporation protects depositors. The Fed’s principal goal will be to prevent a seizing up of credit markets as happened in 2008. Meanwhile, as the Fed likely cuts interest rates in the coming year, this will help to ease the property market crisis.

Assuming that a massive financial crisis can be averted, the next issue will be what to do with an excess supply of office space and how to revive the central business districts of major cities. Also, if a financial crisis does emanate from the commercial property situation, it could potentially be the cause of the next economic downturn.  

China’s residential property market could have a global impact

• After years of excess investment in residential property in China, it is now estimated that China’s excess supply of housing (housing that is not occupied) is roughly 50 million units, enough space to house 150 million people. On the other hand, it is also estimated that the excess supply of housing declined slightly from 2021 to 2023. It was about four years ago that the government imposed new restrictions on property developers, leading to the collapse of the property bubble and a sharp decline in property investment. Thus, excess supply peaked in 2021 and declined thereafter. 

Given that there is a declining population, and an expected sharp decline in the number of young adults, it is not clear when, if ever, equilibrium will return to the housing market. The number of people in their 30s (first-time home buyers) is expected to decline from 220 million in 2020 to 160 million in 2035. 

Also, one of the factors that drove massive investment in housing was a desire for larger homes. Yet that process has likely come to an end, with typical homes in China now having roughly the same amount of space as in Japan or the United Kingdom. Thus, it is likely that residential property investment will be modest in the years to come and that the excess inventory will remain large for a very long time. That, in turn, suggests weak property prices. Given that property is the single biggest source of wealth in China, this could be problematic. 

Also, less property development will mean less global demand for key commodities such as iron ore, and therefore, downward pressure on commodity prices. Indeed, many of China’s steel producers are facing financial challenges. This has led to increased exports of steel in an effort to address excess capacity. China’s steel exports increased 28% from 2022 to 2023. This, in turn, has alarmed the governments of other steel-producing countries. Mexico, for example, has imposed new tariffs on steel imports.

The US government is especially concerned about this situation. A senior official at the US Treasury said that “we are worried that Chinese industrial support policies and macro policies that are more focused on supply rather than thinking about where the demand will come from are both careening towards a situation where overcapacity in China is going to wind up hitting world markets.”

The United States is not only concerned about steel and other products related to the housing market; it is also concerned about products that are related to advanced technologies and clean energy technologies. The same is true of the European Union, which has launched an investigation regarding dumping by China’s electric vehicle industry. China has made it clear that investments in the tech and clean energy sectors will play a role in transitioning away from an economy that was excessively dependent on property investment. Thus, China is subsidizing these new sectors and thereby encouraging more exports. As such, the end of the housing bubble is indirectly contributing to increased economic tensions between China and the West. 

• Meanwhile the People’s Bank of China (PBOC) took new steps to ease the housing crisis and boost household cash flow. Specifically, it cut the benchmark mortgage interest rate (the five-year loan prime rate) by 25 basis points, the most ever. This rate cut will apply to outstanding mortgages, thereby reducing mortgage payments for millions of households. That, in turn, is expected to boost household cashflow, enabling increased consumer spending. The PBOC left other rates unchanged. As such, it is undertaking a targeted effort to ease financial market conditions. 

The five-year prime rate for mortgages was introduced in 2019. Since that time, reductions were very gradual. The last reduction, by 10 basis points, was in June. Thus, the most recent action, although similar to what other major central banks often do, was unusual for the PBOC. In a sense, it sent a signal that the PBOC views the current situation as serious. On the other hand, the mortgage rate has been cut by 200 basis points since 2021 without much effect. Thus, the recent action might not have a big impact. 

Monetary policy alone might not be sufficient to revive the Chinese economy. That is because consumers and businesses might not react to low interest rates due to low confidence. Rather, they hoard cash. Consequently, a better tool might be fiscal policy that would directly boost spending in the economy. Yet the central government is evidently averse to this. It likely worries that it will have to bail out fiscally troubled local governments that are suffering the effects of the housing market collapse.  

Foreign investment in China falls sharply

• In 2023, China had US$33 billion in inbound foreign direct investment (FDI), down 82% from the previous year and the lowest level since 1990. Why is this happening? There are several possible explanations. First, China’s economy is growing relatively slowly and there is a widespread expectation that this will continue. Chinese asset prices are down sharply, demonstrating that domestic investors are likely pessimistic about the outlook. As such, the Chinese market is perceived as less attractive than in the past. 

Second, despite statements from government officials encouraging and welcoming foreign investment, some foreign companies have faced more scrutiny and regulation than previously. Moreover, the government has appeared more supportive of the state sector than the private sector. One likely result that has been noticed is that private sector investment has stalled. 

Third, the increasingly fraught relations between China and Western countries, including both the United States and the members of the European Union (EU), might have given pause to foreign companies before investing in China. The troubled relations raise questions about the possibility of future restrictions on trade and cross-border investment. 

Finally, as China’s labor costs have risen, and as trade restrictions have become more onerous, many companies are looking elsewhere for investment opportunities. Of particular interest are Southeast Asia, India, and Mexico. 

What might be the impact of declining inbound FDI? FDI contributes to an economy’s growth by boosting the capital stock, transferring technologies and knowledge, and often boosting export capacity. Less FDI means less investment, less knowledge transfer, and fewer exports than would otherwise by the case.  

On the other hand, it could be that the worst is over. The government’s data shows that there was a rebound in the fourth quarter when there was a net positive inflow of FDI after a net outflow in the third quarter. Moreover, inbound FDI by German companies hit a record high in 2023. Many German companies, which previously based their competitiveness on access to cheap Russian energy, are now investing elsewhere.  

Eurozone inflation eases, but problems remain

• When inflation in Europe and North America began to surge three years ago, it was largely due to supply chain issues. The pandemic had disrupted supply chains while consumers had massively shifted toward spending on scarce goods. These factors led to the initial surge in prices. This was later exacerbated by the start of the conflict in Ukraine. The sharp decline in inflation in the past two years largely reflected the reversal of the factors that initially generated inflation. Consumer spending shifted back toward services, supply chain disruption eased, and oil prices reversed course. 

Yet inflation, while much lower than previously, is not yet defeated. And that is because the current inflation has to do with demand rather than supply factors. Labor markets are unusually tight, generating large wage increases that are passed onto consumers in the form of higher prices. It is concern about this that has led major central banks to retain tight monetary policies, hoping that their efforts will weaken labor markets and suppress wage pressure.

Which brings us to the Eurozone. There, inflation has receded significantly and is getting quite close to the European Central Bank’s (ECB) target of 2% inflation. Yet inflation in services, which is labor-intensive, remains far too high. Thus, despite progress, the ECB is likely to keep its benchmark interest rate at an elevated level for many more months. Let’s look at the data.

In January, consumer prices in the 20-member Eurozone were up 2.8% from a year earlier and were down 0.4% from the previous month. When volatile food and energy prices are excluded, core prices were up 3.3% from a year earlier, the lowest since March 2022. Core prices were down 0.9% from the previous month. Energy prices were down 6.1% from a year earlier and up 1.2% from the previous month. Food prices were up 5.6% from a year earlier and up 0.9% from the previous month. Thus, food price inflation remains a problem.

Notably, non-energy industrial prices were up only 2% from a year earlier and down 2.4% from the previous month. Thus, goods prices are no longer a problem. The problem remains with services where prices were up 4% from a year earlier (unchanged for the last three months) and down 0.1% from the previous month. Services are mostly labor-intensive. The large wage gains that have taken place in the Eurozone are feeding into service prices, preventing overall inflation from receding to the 2% target.

For the ECB, this is a conundrum. After all, the longer monetary policy remains tight, the more it will weaken a nearly dormant economy that barely grew in 2023. Yet to cut rates now risks allowing inflation to rebound. The ECB has signaled a likelihood that it will keep rates high until the second half of this year. There are two things that could happen that might change the ECB’s calculus. First, if labor productivity accelerates, then businesses can boost wages without raises prices commensurately. Second, if the supply of labor rises quickly (through greater participation or more immigration) it would dampen wage pressure. Absent these, the ECB will likely keep rates high for longer.

Week of February 19, 2024

• The consequences of China’s demographics
• Can India continue to grow rapidly?
• US inflation stalls. What next?
• US retail sales decline in January. Should we be worried?
• How low will interest rates go?

The consequences of China’s demographics

• China is undergoing a vast demographic shift. In 1987 there were over 25 million live births in China. By 2016 this was down to 17.9 million. And then it plunged. In 2023, there were only 9 million live births. Assuming there is not a dramatic rebound in births (unlikely given the sharp decline in the number of women of child-bearing age), this will have major implications in the years to come. For example, the number of school-age children is falling rapidly, likely leading to a big drop in the number of teachers employed. By one estimate, the number of people employed to teach children will drop 1.9 million by 2035. This will reduce the cost of education for local governments. Yet this will be offset by the need to spend more on an increasing elderly population.

• Indeed, as the school-age and working-age population declines in the coming years, this will be partly offset by a rise in the number of retirees. That, combined with fewer working-age people, is expected to put considerable pressure on pensions, health care, and other services for the elderly. One way to offset that would be to raise the age of retirement. Currently, China has unusually low retirement ages: 60 for men, 55 for female office workers, and 50 for female blue-collar workers. The government has indicated that it intends to gradually raise retirement ages, but this process has not yet begun. By one estimate, raising the retirement age to 65 by 2035 would reduce the pension budget shortfall by 20% and boost pension contributions by 30%. Notably, the above-65 population is expected to rise from 15.4% of the population in 2023 to 25.1% in 2035.

Meanwhile, the working-age population is falling rapidly, a process that is expected to continue for a long time. Not only does this put pressure on pensions and health care; it also impacts economic growth. Absent an offsetting acceleration in labor productivity, a decline in the working-age population necessarily implies slow economic growth. In the past few decades, two things contributed strongly to productivity growth: rural-urban migration and a massive inflow of foreign investment. Both are now in decline. This bodes poorly for acceleration of productivity growth. Moreover, the increasing emphasis on the state sector, which traditionally had slower productivity growth than the private sector, also bodes poorly for productivity growth. 

On the other hand, the decline in the working-age population will intensify labor shortages, thereby boosting labor costs and creating an incentive for investments in labor-saving and/or labor-augmenting technologies. That, in turn, could boost productivity. 

Also, the very long term looks concerning. The Shanghai Academy of Social Sciences (SASS) predicts that China’s population will shrink from about 1.4 billion today to 525 million by 2100. It is unlikely that anyone reading this article will be alive in 2100, which means we won’t get to see what happens. But what we do know is that, barring war, famine, or pestilence, this kind of population decline is unprecedented in human history. The SASS also says that, by 2100, the working-age population will fall to 210 million, an 80% decline from today. 

Getting back to now, in the short term, China’s demographics will have a global impact. First, the demographic trends lessen the likelihood that China can overtake the United States as the world’s largest economy. This potentially lessens China’s geopolitical and economic footprint and influence. Second, China’s population and rate of economic growth have already been overtaken by India. Although India’s GDP remains far below that of China, that will likely change in the future, thereby increasing India’s influence. Already there are reports that global companies and investors are increasingly betting on India and reducing exposure to China. Finally, a smaller Chinese population will mean reduced demand for both agricultural and mineral commodities. That, in turn, will influence global commodity markets and prices.

Can India continue to grow rapidly?

• Lately, there has been much excitement about India on the part of investors and global companies. India’s strong economic growth, juxtaposed against China’s troubles, has led to enthusiasm for India as a potential alternative to China. Is this realistic? Can India’s strong growth be sustained? I believe the answer to these questions is yes. India has several attributes and policies that are likely to enable relatively strong growth to continue.

In the long run, economies grow for two reasons. First, more employment leads to more output. Second, more output per worker (productivity) leads to more output. In the case of India, the demographics are very favorable. Unlike in China, the working-age population is growing rapidly and will continue to grow for another two decades. 

As for productivity, it is affected by several factors. First, improvements in human capital boost productivity. A more skilled and educated workforce is a more productive workforce. Moreover, a literate and educated workforce is available to implement new technologies, thereby boosting productivity. In the case of India, the share of the population in tertiary education has soared since the start of this century. In addition, educated Indians have been responsible for a high level of entrepreneurship. They have also attracted considerable investment into the IT sector. 

Second, productivity is boosted by investments in public and private infrastructure, boosting economic efficiency as well as hygienic conditions, which can influence public health. Spending on public infrastructure has surged, with spending on highway construction tripling in the past decade. Plus, the share of households with electricity has increased from 60% ten years ago to 97% today. There has also been a major investment in indoor plumbing. Better public health will mean less illness and better ability of children to perform well in school.

Third, productivity is boosted by investment in technology. India now has a strong digital infrastructure. The share of the population with internet access has risen sharply in recent years. Moreover, overall investment has increased, now accounting for about 30% of GDP, similar to that of many East Asian nations. This is a sea change from the past when India seriously underinvested. Plus, inbound foreign direct investment (FDI) has surged and is now higher as a share of GDP than in China. Foreign investment brings new technologies as well as expats with expertise. It also stimulates domestic entrepreneurship on the part of workers with experience with foreign companies. 

Finally, productivity improves when barriers to economic efficiency are removed. In India, this has involved a sharp decline in import tariffs, although they remain too high. In addition, India’s adoption of a goods and services tax (GST) in 2017 removed obstacles to inter-state economic transactions, enabling the creation of a single national market. 

The result of these initiatives is that India is now growing strongly and is set to continue growing strongly in the years to come. Moreover, strong growth can beget strong growth. That is, strong economic conditions engender confidence on the part of domestic and global businesses, thereby leading to increased investment and adoption of new technologies. Plus, good economic conditions will likely attract more attention from India’s massive and successful diaspora. In the past, China benefitted massively from investment by its own diaspora. This is not to say that India has no problems or headwinds. For example, the female share of the labor force is too low and has been falling. This is a significant obstacle to faster growth. Still, on balance, the future seems positive.

US inflation stalls. What next?

• The US government reported that inflation in January was higher than investors had expected. This led investors to reevaluate expectations as to when the Federal Reserve will start to cut interest rates. The result was that equity prices fell, bond yields rose, and the value of the US dollar increased against major currencies. Yet it is not clear that investor pessimism was entirely warranted. Increases in the cost of shelter contributed substantially to inflation. Absent shelter, inflation was very low. Moreover, shelter inflation is expected to abate. Let’s look at the details:

In January, the consumer price index (CPI) was up 3.1% from a year earlier, down from 3.4% in December but the same as in November. In fact, the annual rise in the CPI has fluctuated between 3% and 3.7% since June. In other words, it is not getting better. Before June, the inflation rate had been steadily declining since mid-2022. Thus, it could be that inflation is getting stuck. Also, consumer prices were up 0.3% from December to January, the highest monthly rate since September. 

When volatile food and energy prices are excluded, core prices were up 3.9% in January from a year earlier, the same as in November, which was the lowest in 2 and a half years. That is the good news. The bad news is that core prices were up 0.4% from December to January, the biggest monthly increase since April of last year. Moreover, monthly core inflation has been mostly on an upward trend since June of last year. This raises serious questions about whether disinflation has stalled. Indeed, it is this concern that led to the recent market reaction.

Going further into the details it is apparent that there is some good news. Many categories of goods experienced deflation in January. In fact, durable goods prices were down 1.6% from a year earlier and down 0.5% for the month. Prices of non-durables were up 0.9% from a year earlier. However, when food prices are excluded, non-durables were down 1% from a year earlier and down 1.4% for the month. 

Thus, almost all inflation was in services, with prices up 4.9% from a year earlier and up 0.7% for the month. Yet a large part of services consists of shelter (housing), where prices were up 6% from a year earlier and up 0.6% for the month. When shelter is excluded from the CPI, overall prices were up only 1.5% from a year earlier and up 0.1% for the month. Moreover, it is expected that the shelter component of CPI inflation will decelerate in the months to come. That suggests that underlying inflation will likely diminish. 

Still, service inflation remains a problem. Excluding shelter, service prices were up 3.6% in January from a year earlier and up 0.6% for the month. Services tend to be labor-intensive, and labor costs continue to rise. This is what concerns the Federal Reserve. Given the extreme tightness of the labor market, it is not surprising that average hourly earnings accelerated in January. Unless wage inflation diminishes or is offset by a sharp rise in labor productivity, it will be difficult to reduce inflation to the 2% target. And that is why the Fed is likely to keep interest rates high for many more months.

US retail sales decline in January. Should we be worried?

• In January, employment grew spectacularly in the United States while real wages continued to advance. Measures of consumer confidence increased sharply. Given that, one might have expected strong retail spending growth in January. Alas, it was not meant to be. Instead, retail sales fell. How can this be explained? First, retail spending involves goods, and goods prices have been falling. The government reports retail sales in nominal dollars (not adjusted for inflation). So, a decline in spending might partly reflect a decline in prices. Moreover, the two categories that involved rising prices (groceries, restaurants) saw increased retail spending. 

Second, the retail sales data is adjusted for seasonal variations in spending. That is, spending surges during the holiday season and then declines afterwards. The government adjusts for this so that there is not a dramatic drop in reported spending in January. However, it could be that seasonal patterns are changing in ways not yet reflected in the data. Moreover, there was unusually cold weather in January, which might have dampened willingness to go out to shop. 

Lastly, despite strong job growth, there are other economic factors that could be dampening the willingness to spend. First, although job growth was strong in January, full-time employment has not increased since last summer. Many people are taking part-time work. Second, it is possible that US households have finally exhausted the excess savings accumulated during the pandemic. Third, although the delinquency rate on household debt remains historically low, the number of households transitioning into delinquency has accelerated to a level higher than prior to the pandemic. This suggests increasing financial stress for many households. 

In any event, here are the details of the retail sales data: In January, retail sales were down 0.8% from the previous month. Many categories experienced a sharp decline. This included automotive (down 1.7%), home improvement (down 4.1%), drugstores (down 1.1%), gasoline stations (down 1.7%, mainly due to lower prices), and non-store retailers (down 0.8%). On the other hand, spending was up at department stores (up 0.5%), grocery stores (up 0.6%), and restaurants (up 0.7%). 

How low will interest rates go?

• It has become almost an article of faith that major central banks in Europe and North America will begin to cut interest rates sometime in the coming year. Thus, the question arises as to how low interest rates will go. The answer depends, in part, on what is known as the neutral interest rate, also known as R*. This is the real (inflation-adjusted) rate that neither stimulates nor weakens the economy. It is the rate that leaves both inflation and the economy steady. A rate higher than R* is a tightening of monetary policy that will weaken the economy and reduce inflation. A lower rate is one that stimulates the economy and allows for higher inflation. The problem is that the level of R* can never be known. Rather, we can estimate R*, thereby providing central banks with guidance. Yet this is difficult, and different economists often come up with wildly different estimates of R*. 

It is widely accepted that R* fell sharply in Europe and North America following the global financial crisis in 2008–09. In the United States, it is widely believed that, in the decade following that crisis, R* was roughly 1% or less. That means, with 2% inflation, the neutral nominal interest rate was no higher than 3%. Indeed, the Federal Reserve kept its policy rate closer to zero during the first few years after the crisis, trying to boost inflation. The question now is whether R* reverts to the pre-pandemic level or goes higher.

What factors might cause a low R*? Factors that cause slow growth can mean a low R*. This would include poor demographics (slow growth of the working-age population) and/or low productivity growth. In addition, a high level of savings relative to the demand for funds can lower R*. Currently, the indigenous labor force is growing slowly. On the other hand, immigration has boosted labor force growth. Productivity, which grew slowly for a long time, is now accelerating. It remains unclear if this will continue.

What factors might cause R* to rise above the pre-pandemic level? First, a high level of government borrowing relative to savings would boost the natural interest rate. Second, increased business investment can boost R*. In the coming years, there is an expectation that business investment will accelerate, driven by climate factors, supply chain redesign, and demand for radically new technologies. 

Given that we don’t know which factors will dominate, there is currently a debate about R*. This, in turn, will influence the decisions made by central banks. Managing monetary policy is hard, in part because R* cannot be known with certainty, and in part because monetary policy acts with a lag.

Week of February 12, 2024

• Drought in Panama Canal threatens to disrupt trade
• US-China trade not as disrupted by tariffs as expected
• Chinese trade patterns are shifting substantially
• Chinese deflation continues
• Japanese household sector remains weak
• Japanese immigration accelerates

Drought in Panama Canal threatens to disrupt trade

• While much attention has been paid to the transport crisis in the Red Sea and the resulting increase in shipping costs, another crisis is taking place on the other side of the world. A severe drought has plagued the Panama Canal. This has resulted in restrictions on the number and size of ships that can pass through the canal. The Panama Canal Authority has raised tolls to manage the shortage of capacity. The result has been a sharp rise in the cost of shipping goods from Asia to the East Coast and Southern Coast of the United States. The cost of shipping a container from Japan to Houston, for example, is up about 150% since mid-2022. 

Blame for the drought has been placed on climate change as well as on the El Nino season. However, a new study suggests that it also has much to do with the deforestation of the Amazon basin. That is, the canal is highly dependent on rainfall, which maintains water levels in lakes that supply water to the canal. In recent years, due to deforestation in the Amazon, rainfall levels have been historically low. The result is that the water levels in the lakes adjacent to the canal have fallen to record lows. 

The Amazon rainforest, the largest such forest in the world, has been sufficiently depleted, so much so that it is likely at a tipping point where it will no longer produce large volumes of rainfall. This is according to several studies by leading scientists. The result is that, in 2023, the Amazon experienced its worst drought in recorded history. And, of course, deforestation is contributing to climate change by reducing the number of trees that can absorb carbon. 

Given this, the future of the Panama Canal is now in doubt. If water levels in the canal remain low, or become even lower, it will be hugely disruptive to global trade. The largest customer of the canal is US-based shipping followed by China-based shipping. The US shipping usually involves goods transported between the West Coast and the East and South coasts. Without access to the canal, there will be more demand for ground transportation within the United States. This will include rail and trucking. 

As for goods coming from China, they could be delivered to West Coast ports for ground transportation to the rest of the United States. Or they could go around South America. Finally, energy products are exported from ports in New Orleans and Houston to Asia. Without the Panama Canal, they might travel across the Atlantic, around Africa, and toward Asia. Either way, these alternative routes would likely cause delays, add to costs, and possibly lead to inadequate capacity. 

The irony is that, earlier in this century, a massive investment was made in widening the Panama Canal to accommodate the latest large container ships and tankers. Now, it appears that this investment might not pay off. As a resident of Los Angeles, I recall considerable concern that the widening of the canal would divert ships from the very large and economically important ports of Los Angeles and Long Beach. Now, there will likely be a significant increase in demand for port facilities in southern California.

US-China trade not as disrupted by tariffs as expected

• When, during the Trump Administration, 25% tariffs were imposed by the US government on a wide range of imported goods from China, there was an expectation that this would lead to a sharp drop in US-China trade. It did lead to a moderate decline, but it also led to a diversion of trade. This entailed Chinese firms exporting inputs to Southeast Asia where final products were assembled for export to the United States. Thus, it has been estimated that, even as the share of US-manufactured imports coming from China declined sharply, the Chinese share of value added in goods consumed in the United States has actually increased. 

Plus, Chinese exporters have taken advantage of a loophole in the law that allows packages valued at under US$800 to arrive in the United States tariff-free. Several Chinese companies, such as Shein, sell goods online directly to US consumers and businesses, sending packages that are valued under the US$800 threshold. Even US online sellers such as Amazon allow Chinese companies to sell goods through their websites. Thus, the majority of packages entering the United States using this loophole now come from China. In 2022, 685 million such packages were shipped to the United States, with between 60% and 80% of them coming from China or Hong Kong. It is estimated that the number of packages might have been about one billion in 2023. 

There are calls in the US Congress for closing this loophole. Moreover, former President Trump has vetted the idea of imposing a 60% tariff on all imports from China. One reason the 25% tariffs have not been as impactful as expected is that there is currently excess production capacity in China, putting downward pressure on prices. Yet a 60% tariff could be very impactful, raising prices substantially and putting pressure on producers to shift production elsewhere. That could be problematic given the vast investment that has been made in existing and highly efficient supply chains in China. On the other hand, higher tariffs will create a big incentive to boost shipments of inputs to Southeast Asia for final assembly, thereby evading tariffs while supplying products to the United States.

Chinese trade patterns are shifting substantially

• Mexico is now the biggest exporter to the United States, supplanting China. Last year, US imports from China were down 20% from the previous year. At the same time, US imports from Mexico were up 5% from the previous year. Meanwhile, while US imports of key products from China fell sharply last year, such imports from India and Southeast Asia surged. For example, US imports of laptop computers from China fell 30% last year while imports of laptops from Vietnam increased fourfold. US imports of smartphones from China fell 10% while imports of smartphones from India were up fivefold. 

What is happening? The shift in trade patterns reflects changes in supply chain design. Many global companies, fearful of supply chain disruption due to geopolitical tensions, are diversifying their supply chains away from China. Indeed, inbound foreign direct investment (FDI) into China fell sharply last year. FDI in Southeast Asia and India increased. The result is a shift in trade. Still, many of the products exported from Southeast Asia and India to the United States are made with inputs that come from China. Thus, China’s role is not necessarily diminishing. It is simply shifting. 

Also, exports from other Asian countries are shifting. For example, exports from Japan and South Korea to China have fallen. As a result, the United States has become the biggest destination for Japanese exports for the first time in four years. And South Korean exports to the United States are now larger than Korean exports to China for the first time in 20 years. 

For China, trade with the United States, Europe, and Japan is now of lesser importance than previously. Instead, China’s trade with Southeast Asia, Brazil, and Russia have increased sharply. Going forward, it is likely that this trend will continue and possibly accelerate, depending on the trade policies of the United States, Europe, and Japan. The outcome of the US election could have a big impact on US trade policy.  

Chinese deflation continues

• Deflation continues in China. In January, consumer prices were down 0.8% from a year earlier, the fourth consecutive month of annual deflation. This was the longest such streak since October 2009 at the height of the global financial crisis. Prices were up 0.3% from the previous month. However, in seven of the last 12 months, prices fell from the previous month. Meanwhile, when volatile food and energy prices are excluded, core prices were up 0.4% in January from a year earlier, the lowest since June 2023. Core prices were up 0.3% from the previous month.

Deflation or very low inflation either reflects weak demand and/or excess supply. In the case of China, it is probably a bit of both. Deflation is worrisome in that it boosts real interest rates, increases the real value of debts, discourages consumers from spending, and hurts business confidence. The cure for deflation is often to boost money supply growth through easier monetary policy. That is, by cutting interest rates. 

In the past year, the People’s Bank of China (PBOC), the country’s central bank, has cut rates and cut the required reserve ratio for commercial banks in an effort to spur more credit market activity. Yet this has not prevented deflation. Some analysts suggest that China is suffering from a liquidity trap in which lower interest rates are ignored as consumers and businesses continue to hoard cash. Instead, many people suggest that fiscal stimulus is needed to boost demand. That would entail increased government expenditure, especially with the goal of boosting consumer demand. Yet given the high level of local government debt in China, the government in Beijing might be reluctant to boost its own deficit. It might fear that it will be called upon to support troubled local governments, thereby boosting the deficit. 

Meanwhile, the government has dismissed worries about persistent deflation. It says that the current situation has much to do with volatile food prices and that higher inflation will return in 2024. On the other hand, critics worry that the persistent crisis in the property market, combined with a lack of confidence that growth will accelerate, suggest that deflation or low inflation will likely persist absent a dramatic change in fiscal policy. 

As for fiscal policy, it is not moving in an expansionary direction. In 2021, 2022, and 2023, government spending as a share of GDP declined from the previous year. This partly had to do with reduced revenue due to the property crisis. Local government revenue is down sharply, putting pressure on the central government.

Japanese household sector remains weak

• The Japanese household sector remains in poor shape. In December, for the 21st consecutive month, real (inflation-adjusted) household income fell from a year earlier. Although nominal income was up 1% in December, this fell behind core inflation. The result was that real wages were down 1.9% from a year earlier. Consequently, and not surprisingly, real spending declined as well. In December, real spending fell 2.5% from a year earlier, the 10th consecutive monthly decline. There were especially sharp declines in certain categories of spending including furniture and household utensils (down 10.8%), clothing and footwear (down 7.1%), and education (down 7.7%). 

The weakness of the consumer sector is a concern to the government, which has called on employers to boost wages. Although Japanese inflation is now relatively high compared to the last 40 years, there is a widespread view that it reflects supply problems rather than excess demand. Plus, inflation is already abating. As such, an acceleration in wages is not seen as necessarily inflationary. Meanwhile, the Bank of Japan (BOJ) is now expected to tighten monetary policy sometime soon. That, in turn, will likely lead to a rise in the value of the yen, thereby reducing import prices and suppressing inflation.  

Japanese immigration accelerates

• In Japan, where the working-age population have been declining since 1995 and where the overall population is aging, demographics are stifling economic growth and creating a potential fiscal headache by reducing the ratio of workers to retirees. This puts pressure on funding of pensions and health care. One solution is to allow more immigration, something that Japan was long reluctant to do. Yet that is now changing. Immigration is up substantially. Last year, the number of foreign workers in Japan exceeded two million for the first time and was up 12.4% from 2022.

Meanwhile, a government report says that Japan will require 6.7 million foreign workers by 2040 in order to maintain adequate economic growth. Although the government has taken various steps to encourage people to have more babies, and provided incentives for boosting female labor force participation, it has failed to reduce the shortage of labor. Thus, immigration is now widely seen as the solution.

Still, at 2% of the population, immigrants are a much smaller share of the population in Japan than in most developed economies. About one-quarter of foreign workers are from Vietnam, the largest group. Plus, foreign workers are not encouraged to stay and become Japanese citizens. Japan has long prided itself on cultural homogeneity. Thus, a more diverse population is likely seen by some as disruptive. On the other hand, absent immigration, Japan could see a sharp decline in population and serious fiscal headaches in the years to come.

Week of February 5, 2024

• The US job market is on fire and wages are accelerating
• Federal Reserve retains tight policy
• Productivity could be the key to reducing inflation
• Eurozone inflation eases more than expected
• Eurozone economy remained weak in 2023

The US job market is on fire and wages are accelerating

• It was stunning and unexpected when the government recently announced that January witnessed massive job growth in the United States. Indeed, 2024 got off to a stellar start, with job growth far in excess of anyone’s estimate. Also, from June to November 2023, the lion’s share of job growth took place in the leisure and hospitality and health care sectors, the former having been pummeled during the pandemic. Yet in January, leisure and hospitality barely saw any employment growth, while health care grew moderately. Rather, most job growth came from other sectors of the economy, including manufacturing, retailing, professional services, and government. Moreover, wages accelerated, not surprisingly given the strength of the job market. This led to a surge in bond yields and a rise in the value of the US dollar. Here are the details.