China Trade Surplus: The Great (Re-) Balancing Act

Shanghai, China, 19 August 2009. Western Economists have long attacked China’s trade surplus as being a great source of economic imbalance in the world. Some have gone as far as saying it was the leading source of the Financial Crisis. [br]

They have subsequently lauded the drop in trade surplus. It reached a high of $128 Billion in Q4 2008, but has dropped to $35 Billion in Q2 2009. In real terms (seasonally adjusted to 2007 prices), it has dropped to around $20 Billion, bringing it back to 2005 levels.

Shanghai, China, 19 August 2009. Western Economists have long attacked China’s trade surplus as being a great source of economic imbalance in the world. Some have gone as far as saying it was the leading source of the Financial Crisis. [br]

They have subsequently lauded the drop in trade surplus. It reached a high of $128 Billion in Q4 2008, but has dropped to $35 Billion in Q2 2009. In real terms (seasonally adjusted to 2007 prices), it has dropped to around $20 Billion, bringing it back to 2005 levels.

Macquarie Securities have forecast that China’s current account surplus will drop from 11% of GDP in 2007 (its peak) to 6% in 2009 and 4% in 2010. A monthly trade deficit is possible within the year.

This brings exports down to 24.5% of GDP, down from 35% in 2007. It therefore seems like China is now fulfilling western demands that it shifts its growth drivers from exports to domestic demand. Certainly growth this year has been driven by economic stimulus and domestic lending, both on a larger scale than any other country in the planet.

However this western view looks increasingly wrong-headed.

A few misunderstandings need to be cleared up to get a better picture of what is really happening.[br]

First, it is not really true to say that China’s growth has been fuelled by exports. Exports have only accounted for 10 per cent of China’s growth in the last ten years, according to analysis by The Economist. The current account surplus only became unusually large from 2005 onwards.

Second, it is not true to say the China’s consumers are not spending. China has the world’s fastest growing consumer market. Retail sales averaged 8 per cent growth a year over the last ten years, and this year they have jumped up 17%. (see Welcome to the Future of the World Economy – a Young Chinese Female with Six Pockets.)

However consumer spending growth has been slower than overall economic growth. Consumption as a percentage of China’s GDP has dropped from 50% in 1990 to 35%, half of what it is in the US. Both exports and consumer spending have been growing then, but not as fast as the overall economy. So where is the growth coming from?

It turns out that investment has been the biggest driver of growth in the last 20 years. In 2003 it overtook consumption as the largest component of GDP, and it is forecast to go over 45% this year, thanks to the combination of stimulus spending (most of which is focused on infrastructure) and dropping exports. China is vast and in many places poor, so better roads, trains and ports are all good things. However there are structural reasons why this trend has been exaggerated, and political reasons why it will be a harder re-balancing act than further spurring robust consumer spending with better social safety nets. China has focused on capital-intensive growth in heavy industries such as steel. This growth generates less jobs than people-intensive services industries. As a result, the share of income going to households, both in the form of wages and investment income, has been declining, while the share of profit going to corporates has risen.

That is why the savings rate is misleading. According to the World Bank, consumer saving is only slightly above where it was in 1998 as a proportion of GDP, at around 23 per cent. Corporate saving, however, has ballooned, from 12 per cent in 1998 to 24 per cent in 2008.

State-owned corporations do not have to pay dividends and are given low interest rates from state-owned banks. It also provides incentives and subsidies for these industries, keeps the exchange rate low to boost exports and suppresses land and energy costs. This further boosts corporate profitability and allows them to continually re-invest profits, creating yet more capital-intensive activity.

From an economists point of view, the solutions are fairly obvious. China needs to:

• Liberalize the financial sector. This will both increase the cost of capital for government linked companies, and improve access to capital, and returns on deposits, for consumers and small companies. That in turn will boost consumption and employment in labour-intensive services industries.
• Remove incentives such as tax breaks for capital-intensive industries
• Remove barriers to entry for private companies to some protected service industries
• Force state-owned firms to pay dividends back the government, to invest more in social safety nets such as subsidised medical care and education
• Raise the prices of subsidised industrial inputs such as raw materials, or abolish those subsidies entirely
• Relax land ownership and migration rules
• Let the exchange rate rise to boost consumer purchasing power while reducing excessive investment in manufacturing

While these solutions may be obvious economically, they are unlikely to be possible politically. The key problem is that it would require Beijing to lose control, or at least reduce its access to controlling levers, of large parts of the economy.

China’s success in responding to the global financial crisis has been primarily because it had those controls and so could affect change quickly. Since the Chinese, like most people in the world, think the crisis was made by ‘men with blond hair and blue eyes’, the likelihood of convincing them to embrace the economic system of those same men seems remoter than ever.

However it is likely that they will find their own, uniquely Chinese approach to address at least some of those structural imbalances in the next few years.

Chen Xiulian, EconomyWatch.com