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The US trade gap shrank in June, as US (SPY) imports fell, and exports grew. This contrasts with much of the rest of the world, particularly the Eurozone and East Asia, which seems to be struggling right now. The shrinking US trade gap is no fluke. You don't need a magical crystal ball or training in the "psychic arts" to have seen it coming. Rather, when Adam Smith penned The Wealth of Nations 236 years ago, this is exactly the type of result he might have predicted.


A Simple Example

Let's look at an easy example with only two nations: Japan (EWJ) and the United Kingdom (EWU). We'll create a basket of five goods: computers, bicycles, tables, mattresses, and couches. In order to make things very simple to understand, we'll assume that the Japanese Yen ("JPY") and the British Pound ("GBP") are at parity; or that is to say, that one JPY buys one GBP. We'll also assume that each nation manufactures a "standard quality" so that the computers manufactured in Japan are not superior or inferior to the ones manufactured in the UK.

The table below lays out the price to manufacture all five of the goods in each of the two nations:

Without free trade, you can say that the basket of goods will cost 450 Yen in Japan, and 435 Pounds in the UK. However, the price for the basket of goods falls to 400 in both nations (since the currencies are at parity) with free trade. That's a cost savings of 11.1% for Japanese consumers, and 8.0% for British consumers. It's easy to see how consumers in both nations are better off in this scenario.

When "Free Trade" Isn't Free

Many are under the mistaken impression that the United States has relatively free trade with China and most East Asian nations. In actuality, this is not the case. While blatant tariffs are verboten in this day and age, currency subsidies achieve the exact same objective; and currency subsidies have been popular in East Asia since the 1970's when Japan utilized them.

Japan's experiment looked incredibly promising at first, but did not end well. Japan looked like an economic juggernaut in the 1970's and 80's. The media talked about how they were going to overtake the US. All that ended around 1989, when Japan entered its "Lost Decade". From 1990 to 2010, Japan was one of the worst performing developed economies in the world in terms of GDP per capita, with a paltry 0.79% annualized growth rate. The only two major developed economies that performed worse: Italy and Switzerland at 0.59% and 0.51% annualized growth respectively.

In spite of Japan's woes over the past two decades, other East Asian nations have copied its flawed mercantilistic economic model, with China (FXI) leading the way. Indeed, China's aggressive mercantilism makes Japan's look quite tame in comparison.

Mercantilist maneuvers have a tendency to initially look like they are working, only to collapse in dramatic fashion. Japan's tale of quick success, followed by stagnation may be relatively recent, but it's certainly not the only one out there. The same thing happened to the mercantilist US in the 1930's with the Great Depression. It happened to mercantilist Germany in the 1920's. It happened to the Spanish Empire, which eventually fell into bankruptcy.

China will soon add its name to the list.

The Impact of Currency Subsidies

The pattern with currency subsidies in East Asia has replayed itself numerous times over the past half-century. A nation liberalizes certain aspects of trade. This stimulates its economy, and creates more interest amongst foreign investors. As more money flows into this nation's economy, its currency appreciates versus other currencies (e.g. the US Dollar).

There's nothing wrong with the above pattern, but it's the next step where we begin to see distortions. With liberalized trade, we initially see a surging growth rate in exports, which results in rapid increases in GDP. While this is very beneficial to everyone, policymakers start to become worried when the growth rate begins declining. Mind you, the economy still might be growing at a reasonable pace, but the rate of growth might not be as dramatic as before, and the new growth may be more consumption oriented.

In most cases, policymakers in these nations had already implemented a US Dollar peg, in order to encourage investment, and signal to worldwide investors that their investments were safe. In order to keep the rapid pace of export growth, policymakers in these "new mercantilist" nations decide that instead of re-adjusting the pegs to reflect intrinsic value of their currency, they will instead leave the peg unchanged. This creates a subsidy, since the government is fixing the value of their currency at an artificial level, unsupported by the markets. This creates a host of consequences.

Currency Subsidies in Action

In order to understand how currency subsidies work, let's take another look at our initial example. Let's say that after Japan's initial reforms, they import machinery that allows them to extract minerals more effectively, and manufacture plywood more cheaply. To make things simple, we'll say that there are no other improvements in productivity beyond these two; but that these advances allow the Yen to appreciate versus the GBP, so that it now only costs 0.9 JPY to buy 1 GBP.

Notice that this is exactly the same as the first chart, except that the exchange rate is different. However, since we're no longer at parity, we need to calculate the price of the goods in both Yen and Pounds to understand what's really happening.

The chart below shows the costs to Japanese consumers in Yen.

Now, here's the costs for British consumers in Pounds.

Both nations still benefit from free trade in this new scenario. Japanese consumers achieve 16.3% cost savings, while British consumers achieve a cost savings of 3.8%. (Note that the UK's benefit is likely greater in reality, because in order to simplify the example, we are not looking at the two technologies where Japan had major advancements: mineral extraction and plywood.)

But what happens if Japan pegs the JPY at 1 to 1 with the GBP, providing a subsidy to its own exporters and imposing an effective tariff on British goods? I could show you a new chart, but actually, we'd just revert back to the first chart, with one major difference: while the initial chart shows you the nominal costs of the goods, the two newer charts above show you the real costs of the goods. What's actually happening is that Japan is exporting the benefits of its technological improvements out to the United Kingdom.

In case you'd like to see that in chart form, here is the scenario for Japanese consumers:

And now for British consumers:

Britain is still able to purchase its basket of goods for 400 Pounds, rather than the new price of 418.3 Pounds. This means that British consumers are essentially receiving a 4.4% discount (or subsidy) on the overall basket of goods.

Meanwhile, the price for the new basket of goods for Japanese consumers would be 376.5 Yen without the peg; but with the peg it stays at 400 Yen. In essence, Japanese consumers are paying a 6.2% tax (or tariff if you prefer) on their goods.

What Else is Happening?

There is something else going on here. We noted that Japanese consumers are essentially paying a 23.5 Yen tax, while British consumers are receiving an 18.3 Pound subsidy. It might not be immediately evident, but those figures don't balance out. If you convert 18.3 Pound subsidy into Yen at the 0.9 JPY to 1.0 GBP exchange rate, it comes out to 16.5 Yen.

Japanese consumers are paying a 23.5 Yen tax, while British consumers are receiving 16.5 Yen in benefits. There's a 7 Yen difference between those two figures. This is a transfer of wealth, but it's also a destruction of wealth.

It's a debatable issue as to whether Japan's currency subsidy benefits the British. We've shown that the subsidy reduces the costs for the basket of goods, but it also means that British exports sag, which typically results in higher unemployment and possibly lower/stagnant wages in the UK.

Since most export industries that are highly cost sensitive employ lower-skill workers, this ends up harming the working class (i.e. lower-middle income groups) the most. The wealthy and large swaths of the middle class benefit from lower prices for goods; but the net result is a greater disparity of wealth. This results in more government payouts for unemployment; either directly through welfare or unemployment insurance, or indirectly via a higher crime rate. So even if Britain is importing part of Japan's wealth, it comes at a cost, making it debatable as to whether the UK benefits from this arrangement.

If it's debatable whether the UK benefits, Japan clearly does not. Japanese capitalists who own stakes in exporting industries benefit since the subsidies will increase their volume of sales, but almost everyone else gets burned. Middle-class consumers must pay higher prices for goods. Inflation strips away the value of salaries every year. Overall, the vast majority of Japanese are worse off in our scenario; the only beneficiaries are a select few wealthy individuals. But once again, we can see how this mercantilistic system can increase the gap between the wealthy and the poor.

If you replace Japan with China in the above scenarios, you can better understand the dismal economics behind China's Dollar peg.

Why a Weaker Renminbi Does Not Benefit China

Back to the issue of the shrinking US trade gap; it may seem counter-intuitive that a weakening renminbi ("RMB") would result in a smaller US trade gap. After all, if Chinese goods are getting cheaper, shouldn't the US trade gap widen? The reason why this isn't the case: Chinese goods aren't actually getting cheaper.

The weakening renminbi (CNY)(FXCH) is a result of lower productivity, inefficient resource usage, and wealth destruction. Investors are pulling out of China as they've discovered the massive issues with investment there. With less foreign investment pouring into China, the RMB weakens intrinsically. This can be seen in China via higher input prices.

Let's go back to our example with the UK and Japan; noting that China is essentially taking on the role of Japan in the scenario. In the last scenario, the Yen strengthened intrinsically, so that 0.9 Yen would buy 1.0 Pounds. However, the Japanese government instituted a peg so that it still cost 1.0 Yen to buy 1.0 Pounds. Now, let's say that things reverse and the Yen weakens intrinsically back to 1.0 Yen.

Except, what's actually happening is that the costs of production are going up for all Japanese goods. So here's our modified scenario:

As you can see, Japan is actually only competitive on one product out of the five now. Since the intrinsic value of the Yen is the same as the pegged value, the currency subsidies have actually disappeared. Indeed, if the Yen weakens more, let's say to 1.1 JPY to 1.0 GBP, then the peg will actually act as a tariff on Japanese goods and a subsidy for British goods.

This brings us to a common misconception in regards to currencies. We typically think of a weaker currency resulting in more exports and a stronger currency resulting in fewer exports. This is overly simplistic and ignores cause and effect. It's not that a stronger currency results in fewer exports; it's that an increase in the gains from exports and an increase in savings from imports results in a stronger currency. Too often, we analyze this from the wrong direction and assume that a currency movement either benefits or harms a nation; rather than seeing it as a result.

Mercantilistic philosophy revolves around the flawed idea that having a positive balance of trade is vital for wealth creation. It's not. Real wealth can be created from greater exports; but it can also be created from cost savings from imports. While artificially weakening a nation's currency will result in more exports, it will also result in higher costs. In a comparative sense, it also leads to lower productivity and lesser wealth.

China's weakening currency is a result of flawed policies that have destroyed wealth. If the RMB weakens too much, it could quickly reverse from being a currency subsidy, into being an internal tariff that lowers the costs of outside goods, while increasing the costs of Chinese goods. At that point, China's only solution would be to de-peg. This is exactly what I believe will happen in China.

Why the Weaker RMB Reduces US Trade Gap

Now that we see how the weakening RMB reduces the value of the currency subsidy for Chinese exports, while also reflecting lower productivity, we can see how it would result in a lower US trade gap. Since the currency subsidy is effectively a tariff on US goods, that tariff disappears as the RMB weakens and its intrinsic value approaches its pegged value. Since this will create the most efficient result for both Chinese and American consumers, this could theoretically result in an increase in the overall volume of trade.

Of course, in the real world, these sorts of shifts don't necessarily take place over night. It could take awhile for the US (and other nations) to take advantage of their greater competitiveness, now that the Chinese subsidies are being weakened.

All of this has happened before with Japan (which is one reason I chose Japan for my example). Take a look at the chart below, which shows the US trade balance for the past thirty years.

(click to enlarge)

Take a look at the 1980's and you can see that the US trade deficit widened significantly from 1980 to 1987. In late 1985, the Plaza Accord was signed between the US, Japan, the UK, France, and West Germany. Within about two years, the US trade deficit began to narrow rapidly. It was after the Plaza Accord and the bursting of the Japanese Asset Bubble in 1989 that the US economy seemed to gain its footing again. I don't view this as merely a coincidence; the weakening of the trade distortions from Japan resulted in a stronger US economy.

The chart above is somewhat misleading in one regard: it's based on raw US Dollars, rather than looking at the trade balance as a % of GDP. I could not find a public use, ready-made trade gap as a % of GDP chart on the Internet. For those that are interested, you can create a chart with the current account deficit as a % of GDP at TradingEconomics; which should give similar results.

When you at the gap as a % of GDP, the trade deficit peaked around 3.75% in the mid 80's, was almost completely eliminated by 1992, and then hovered below 2% of GDP till about late 1998. At that point, it began growing dramatically, increasing all the way to 6% of GDP by 2007. It's not a coincidence that the trade deficit began to rapidly grow again after 1998. That was about the same time that China began to use its currency as a way to subsidize exports.

From this data, it would seem apparent that China is the primary driver behind the US trade gap and that the vehicle it uses to achieve this is currency subsidies. Once the intrinsic value of the RMB begins to fall dramatically, as a result of weaker confidence in China, and China's overall wealth destruction, the subsidy disappears, and trade begins to slowly normalize.

How It Will Play Out

Unfortunately, it's difficult to say what the timeframe for all of these changes might be. Even after the Plaza Accord went into effect, it took about 2 years before the US trade gap began to shrink. The distortions that China (and many other East Asian nations) has (have) created are much more dramatic than the ones created by Japan in the 1980's. It might take several years before economies elsewhere begin to adapt to a low- or zero- subsidy environment. But I do think inevitably, that the US trade gap will shrink as a result and we might already being witnessing that. There will likely be bumps in the road, but I expect that trend to continue over the next decade.

How to Invest

The Chinese economy will likely suffer a "hard landing" as a result of its mercantilistic policies, just like Japan ("Lost Decade") and the US ("Great Depression") before it. Since April 2011, the FTSE China 25 Index has declined nearly 30%. This has many wondering if there's value in China right now; I view it more as a value trap.

The Japanese stock market fell nearly 60% from its 1989 peak till the end of 2000. Even more terrifying, the US's Dow Jones Industrial Average (DIA) fell 89% from its 1929 peak to its 1932 bottom. While I'm not arguing that the circumstances are precisely similar in China, we can at least see from these two real-world examples that there could still be a long way to fall. Therefore, I would keep away from China as an investment until we see significant reforms from the Chinese government, both on trade policy, and on liberalizing its financial sector.

It's not just China that will suffer, however. China's currency distortions have been creating a massive amount of demand for commodities such as copper, coal, and steel. Copper producers such as Freeport McMoran (FCX) and Southern Copper (SCCO) might look attractive due to high dividend yields and big earnings, but a return to normalized profit margins and lower volumes could end up slicing earnings anywhere from 50% to 90% below their peaks in 2011. This is why the copper producers may still have a long way to fall.

The other sector I'm increasingly skeptical of is coal (KOL). Coal has suffered a big hit due to issues in China, but it's also been suffering due to low natural gas prices in the US. For this reason, coal may seem attractive as natural gas prices rise; however, many coal producers are more dependent upon the sale of coking coal to places like China than many investors might realize. Even with rising gas prices in the US, it's possible that some coal miners will continue to be poor investments for the next few years.

While I believe that the weakening of trade distortions will benefit the US, it's important to realize that we have our own issues that could stand in the way of a fuller recovery. However, I still believe housing prices will improve and that real estate related investments can be attractive for the next decade. The homebuilders have already taken off, but there remains a few attractive housing-related plays, such as Howard Hughes Corp. (HHC).

Another potential impact of China's downturn could be rising interest rates in the US. US interest rates have been held artificially low for over a decade as a result of China's Dollar peg, which required it to buy massive amounts of US Dollar assets. As China is forced to start selling those assets, it makes sense the Dollar could weaken (not against the RMB, but against some other currencies) and interest rates rise. Rising interest rates could benefit banks (IAT)(KBE) and insurers (KIE) in the US. Given how beaten down the banks and insurers are right now, this could be a very attractive area for investment.

Overall, I do believe that there are some attractive areas to consider, but it's difficult to completely tell what will happen in the US. The more important takeaway is to remain skeptical of China and many commodities as China's economy corrects.

Source: Shrinking U.S. Trade Gap No Fluke; Weakening Asian Export Subsidies The Reason

Additional disclosure: I am short and/or own long-dated put options on FXI, FCX, and SCCO. I am long HHC. I own long positions in the banking, housing, and insurance sectors.