A China rebalancing act?

China's current account surplus has dropped dramatically in the last two years. But this healthy development may just be temporary – though if it is the world has much greater economic worries.

Lowy Interpreter

In 2010, China's current account surplus was over 10 per cent of GDP. Just a year later the surplus had fallen to less than 3 per cent as imports grew faster than exports. The International Monetary Fund is expecting a further fall to 2.3 per cent this year, before rising to around 4 per cent over the next few years.

Does this mean that one of the key international imbalances is disappearing?

Before we cross this off the list of international economic worries, we might recall the perils of forecasting the Chinese economy: just a year ago the International Monetary Fund was forecasting 6 per cent for this year's surplus, rising to 8 per cent later. The IMF says the main explanation for the turnaround is China's terms of trade: its import prices (mainly commodities) have risen and its export prices (manufactures) have fallen.

But that doesn't seem to be a new story. Similarly, weak world demand (especially from Europe and the US) is not a new story. Maybe the 30 per cent change in China's real effective exchange rate since 2005 (when the yuan was given a bit of room to move) has had something to do with it. With wages growing at 15 per cent a year, international competitiveness is quickly eroded.

The wider story of re-balancing should show up in the domestic counterpart of the external surplus (if an abstemious country spends less than it produces, it must be accumulating an external surplus). It's hard to see much re-balancing going on here: we might expect to see investment trimmed back as growth slows from over 10 per cent to 8 per cent. But investment is still running at almost half of GDP. We might expect to see consumption rising towards the 60-70 per cent of GDP seen elsewhere, but it is still below 50 per cent and falling.

These statistical puzzles will sort themselves out over time. Current accounts are the net of two much larger figures (imports and exports, plus the services and income account), so it's easy to get forecasts wrong.

But a heated slanging match with the US was based on the bloated surplus; as recently as October the US Congress was still threatening to declare China to be an 'exchange rate manipulator' and impose trade sanctions. Presumptive GOP presidential candidate Mitt Romney has taken this a step further, announcing that on his first day in office he will declare China to be a currency manipulator.

The external surplus figures ought to have enough substance to silence the debate, making it easier to resist branding China a currency manipulator and imposing sanctions. This level of surplus is within acceptable international norms and China's foreign exchange reserves have grown only slowly since the middle of last year.

In any case, most Americans look at the wrong numbers: the bilateral trade surplus between the two countries. This is still large. In fact it is larger than China's total surplus, which is a reminder of why it's not sensible to focus on bilateral balances. American has a deficit with China, but a surplus with other countries, and you can't complain just about your surplus trade partners.

But the detailed story of China's re-balancing, if indeed this is happening, is still waiting to be unravelled. In due course we will see whether this is 'good' or 'bad' re-balancing.

Does it simply reflect flaccid world demand resulting from Europe's chronic recession and America's insipid recovery? So far China seems to have made up for the fall in net exports by keeping investment growing at what is probably an unsustainable rate, accounting for around half of GDP. Can this torrent of investment (with its risks of fast-trains-to-nowhere) be transformed and diverted into higher consumption, getting investment back to the more normal share of GDP? How will regional countries supplying commodities and supply-chain inputs fare if China's export growth slows, and consumption becomes a larger element in GDP? How well will the countries currently exporting capital goods to China (notably Japan and Korea) adapt if Chinese import demand switches to consumption goods? Will China soften the domestic impact of the re-balancing by 'on-shoring' production of supply-chain inputs that are currently imported?

These issues of economic managements are challenging, but far less intractable than those faced by Europe, or even the US, with its longer-term fiscal unsustainability. China's international imbalance should be low on the list of world worries.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.

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